CORPORATE FINANCE LECTURE NOTE PACKET 2 CAPITAL

CORPORATE FINANCE LECTURE NOTE PACKET 2 CAPITAL STRUCTURE, DIVIDEND POLICY AND VALUATION B40.2302 Aswath Damodaran

Aswath Damodaran 1

CAPITAL STRUCTURE: THE CHOICES AND THE TRADE OFF “Neither a borrower nor a lender be” Someone who obviously hated this part of corporate finance

Aswath Damodaran 2

3

First principles

Aswath Damodaran

3

The Investment DecisionInvest in assets that earn a

return greater than the minimum acceptable hurdle

rate

The Financing DecisionFind the right kind of debt for your firm and the right mix of debt and equity to

fund your operations

The Dividend DecisionIf you cannot find investments

that make your minimum acceptable rate, return the cash

to owners of your business

The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used

to fund it.

The return should relfect the magnitude and the timing of the

cashflows as welll as all side effects.

The right kind of debt

matches the tenor of your

assets

How much cash you can

return depends upon

current & potential

investment opportunities

How you choose to return cash to the owners will

depend whether they prefer

dividends or buybacks

Maximize the value of the business (firm)

The optimal mix of debt and equity

maximizes firm value

4

The Choices in Financing

Aswath Damodaran

4

¨  There are only two ways in which a business can raise money. ¤  The first is debt. The essence of debt is that you promise to make fixed

payments in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your business.

¤  The other is equity. With equity, you do get whatever cash flows are leY over aYer you have made debt payments.

5

Global Pa[erns in Financing…

Aswath Damodaran

5

6

And a much greater dependence on bank loans outside the US…

Aswath Damodaran

6

7

Assessing the exis]ng financing choices: Disney, Vale, Tata Motors, Baidu & Bookscape

Aswath Damodaran

7

Stage 2Rapid Expansion

Stage 1Start-up

Stage 4Mature Growth

Stage 5Decline

Financing Choices across the life cycle

ExternalFinancing

Revenues

Earnings

Owner’s EquityBank Debt

Venture CapitalCommon Stock

Debt Retire debtRepurchase stock

External fundingneeds

High, but constrained by infrastructure

High, relative to firm value.

Moderate, relativeto firm value.

Declining, as a percent of firm value

Internal financing

Low, as projects dryup.

Common stockWarrantsConvertibles

Stage 3High Growth

Negative orlow

Negative orlow

Low, relative to funding needs

High, relative tofunding needs

More than funding needs

Accessing private equity Inital Public offering Seasoned equity issue Bond issuesFinancingTransitions

Growth stage

$ Revenues/Earnings

Time

8

9

The Transi]onal Phases..

Aswath Damodaran

9

¨  The transi]ons that we see at firms – from fully owned private businesses to venture capital, from private to public and subsequent seasoned offerings are all mo]vated primarily by the need for capital.

¨  In each transi]on, though, there are costs incurred by the exis]ng owners: ¤  When venture capitalists enter the firm, they will demand their fair

share and more of the ownership of the firm to provide equity. ¤  When a firm decides to go public, it has to trade off the greater access

to capital markets against the increased disclosure requirements (that emanate from being publicly lists), loss of control and the transac]ons costs of going public.

¤  When making seasoned offerings, firms have to consider issuance costs while managing their rela]ons with equity research analysts and rat

10

Measuring a firm’s financing mix …

Aswath Damodaran

10

¨  The simplest measure of how much debt and equity a firm is using currently is to look at the propor]on of debt in the total financing. This ra]o is called the debt to capital ra]o:

Debt to Capital Ra]o = Debt / (Debt + Equity) ¨  Debt includes all interest bearing liabili]es, short term as well

as long term. It should also include other commitments that meet the criteria for debt: contractually pre-‐set payments that have to be made, no ma[er what the firm’s financial standing.

¨  Equity can be defined either in accoun]ng terms (as book value of equity) or in market value terms (based upon the current price). The resul]ng debt ra]os can be very different.

11

The Financing Mix Ques]on

Aswath Damodaran

11

¨  In deciding to raise financing for a business, is there an op]mal mix of debt and equity? ¤  If yes, what is the trade off that lets us determine this op]mal mix?

n What are the benefits of using debt instead of equity? n What are the costs of using debt instead of equity?

¤  If not, why not?

12

Costs and Benefits of Debt

Aswath Damodaran

12

¨  Benefits of Debt ¤  Tax Benefits ¤  Adds discipline to management

¨  Costs of Debt ¤  Bankruptcy Costs ¤  Agency Costs ¤  Loss of Future Flexibility

13

Tax Benefits of Debt

Aswath Damodaran

13

¨  When you borrow money, you are allowed to deduct interest expenses from your income to arrive at taxable income. This reduces your taxes. When you use equity, you are not allowed to deduct payments to equity (such as dividends) to arrive at taxable income.

¨  The dollar tax benefit from the interest payment in any year is a func]on of your tax rate and the interest payment: ¤  Tax benefit each year = Tax Rate * Interest Payment

¨  Proposi'on 1: Other things being equal, the higher the marginal tax rate of a business, the more debt it will have in its capital structure.

14

The Effects of Taxes

Aswath Damodaran

14

¨  You are comparing the debt ra]os of real estate corpora]ons, which pay the corporate tax rate, and real estate investment trusts, which are not taxed, but are required to pay 95% of their earnings as dividends to their stockholders. Which of these two groups would you expect to have the higher debt ra]os?

a.  The real estate corpora]ons b.  The real estate investment trusts c.  Cannot tell, without more informa]on

15

Debt adds discipline to management

Aswath Damodaran

15

¨  If you are managers of a firm with no debt, and you generate high income and cash flows each year, you tend to become complacent. The complacency can lead to inefficiency and inves]ng in poor projects. There is li[le or no cost borne by the managers

¨  Forcing such a firm to borrow money can be an an]dote to the complacency. The managers now have to ensure that the investments they make will earn at least enough return to cover the interest expenses. The cost of not doing so is bankruptcy and the loss of such a job.

16

Debt and Discipline

Aswath Damodaran

16

¨  Assume that you buy into this argument that debt adds discipline to management. Which of the following types of companies will most benefit from debt adding this discipline?

a.  Conserva]vely financed (very li[le debt), privately owned businesses

b.  Conserva]vely financed, publicly traded companies, with stocks held by millions of investors, none of whom hold a large percent of the stock.

c.  Conserva]vely financed, publicly traded companies, with an ac]vist and primarily ins]tu]onal holding.

17

Bankruptcy Cost

Aswath Damodaran

17

¨  The expected bankruptcy cost is a func]on of two variables-‐-‐ ¤  the probability of bankruptcy, which will depend upon how uncertain

you are about future cash flows ¤  the cost of going bankrupt

n  direct costs: Legal and other Deadweight Costs n  indirect costs: Costs arising because people perceive you to be in financial trouble

¨  Proposi'on 2: Firms with more vola'le earnings and cash flows will have higher probabili'es of bankruptcy at any given level of debt and for any given level of earnings.

¨  Proposi'on 3: Other things being equal, the greater the indirect bankruptcy cost, the less debt the firm can afford to use for any given level of debt.

18

Debt & Bankruptcy Cost

Aswath Damodaran

18

¨  Rank the following companies on the magnitude of bankruptcy costs from most to least, taking into account both explicit and implicit costs:

a.  A Grocery Store b.  An Airplane Manufacturer c.  High Technology company

19

Agency Cost

Aswath Damodaran

19

¨  An agency cost arises whenever you hire someone else to do something for you. It arises because your interests(as the principal) may deviate from those of the person you hired (as the agent).

¨  When you lend money to a business, you are allowing the stockholders to use that money in the course of running that business. Stockholders interests are different from your interests, because ¤  You (as lender) are interested in geong your money back ¤  Stockholders are interested in maximizing their wealth

¨  In some cases, the clash of interests can lead to stockholders ¤  Inves]ng in riskier projects than you would want them to ¤  Paying themselves large dividends when you would rather have them keep the

cash in the business. ¨  Proposi'on 4: Other things being equal, the greater the agency problems

associated with lending to a firm, the less debt the firm can afford to use.

20

Debt and Agency Costs

Aswath Damodaran

20

¨  Assume that you are a bank. Which of the following businesses would you perceive the greatest agency costs?

a.  A Large Technology firm b.  A Large Regulated Electric U]lity ¨  Why?

21

Loss of future financing flexibility

Aswath Damodaran

21

¨  When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt.

¨  Proposi'on 5: Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects.

22

What managers consider important in deciding on how much debt to carry...

Aswath Damodaran

22

¨  A survey of Chief Financial Officers of large U.S. companies provided the following ranking (from most important to least important) for the factors that they considered important in the financing decisions Factor Ranking (0-‐5) 1. Maintain financial flexibility 4.55 2. Ensure long-‐term survival 4.55 3. Maintain Predictable Source of Funds 4.05 4. Maximize Stock Price 3.99 5. Maintain financial independence 3.88 6. Maintain high debt ra]ng 3.56 7. Maintain comparability with peer group 2.47

23

Debt: Summarizing the trade off

Aswath Damodaran

23

24

The Trade off for Disney, Vale, Tata Motors and Baidu

Aswath Damodaran

24

Debt trade off Discussion of relative benefits/costs Tax benefits Marginal tax rates of 40% in US (Disney & Bookscape), 32.5% in India (Tata

Motors), 25% in China (Baidu) and 34% in Brazil (Vale), but there is an offsetting tax benefit for equity in Brazil (interest on equity capital is deductible).

Added Discipline

The benefits should be highest at Disney, where there is a clear separation of ownership and management and smaller at the remaining firms.

Expected Bankruptcy Costs

Volatility in earnings: Higher at Baidu (young firm in technology), Tata Motors (cyclicality) and Vale (commodity prices) and lower at Disney (diversified across entertainment companies). Indirect bankruptcy costs likely to be highest at Tata Motors, since it’s products (automobiles) have long lives and require service and lower at Disney and Baidu.

Agency Costs Highest at Baidu, largely because it’s assets are intangible and it sells services and lowest at Vale (where investments are in mines, highly visible and easily monitored) and Tata Motors (tangible assets, family group backing). At Disney, the agency costs will vary across its business, higher in the movie and broadcasting businesses and lower at theme parks.

Flexibility needs

Baidu will value flexibility more than the other firms, because technology is a shifting and unpredictable business, where future investment needs are difficult to forecast. The flexibility needs should be lower at Disney and Tata Motors, since they are mature companies with well-established investment needs. At Vale, the need for investment funds may vary with commodity prices, since the firm grows by acquiring both reserves and smaller companies. At Bookscape, the difficulty of accessing external capital will make flexibility more necessary.

25

6 Applica]on Test: Would you expect your firm to gain or lose from using a lot of debt?

Aswath Damodaran

25

¨  Considering, for your firm, ¤  The poten]al tax benefits of borrowing ¤  The benefits of using debt as a disciplinary mechanism ¤  The poten]al for expected bankruptcy costs ¤  The poten]al for agency costs ¤  The need for financial flexibility

¨  Would you expect your firm to have a high debt ra]o or a low debt ra]o?

¨  Does the firm’s current debt ra]o meet your expecta]ons?

26

A Hypothe]cal Scenario

Aswath Damodaran

26

Assume that you live in a world where (a) There are no taxes (b) Managers have stockholder interests at heart and do what’s best for stockholders. (c) No firm ever goes bankrupt (d) Equity investors are honest with lenders; there is no subterfuge or a[empt to find loopholes in loan agreements. (e) Firms know their future financing needs with certainty

¨  What happens to the trade off between debt and equity? How much should a firm borrow?

27

The Miller-‐Modigliani Theorem

Aswath Damodaran

27

¨  In an environment, where there are no taxes, default risk or agency costs, capital structure is irrelevant.

¨  If the Miller Modigliani theorem holds: ¤  A firm's value will be determined the quality of its investments and not

by its financing mix. ¤  The cost of capital of the firm will not change with leverage. As a firm

increases its leverage, the cost of equity will increase just enough to offset any gains to the leverage.

28

What do firms look at in financing?

Aswath Damodaran

28

¨  There are some who argue that firms follow a financing hierarchy, with retained earnings being the most preferred choice for financing, followed by debt and that new equity is the least preferred choice. In par]cular, ¤  Managers value flexibility. Managers value being able to use capital (on new investments or assets) without restric]ons on that use or having to explain its use to others.

¤  Managers value control. Managers like being able to maintain control of their businesses.

¨  With flexibility and control being key factors: ¤  Would you rather use internal financing (retained earnings) or external financing?

¤  With external financing, would you rather use debt or equity?

29

Preference rankings long-‐term finance: Results of a survey

Aswath Damodaran

29

Ranking Source Score

1 Retained Earnings 5.61

2 Straight Debt 4.88

3 Convertible Debt 3.02

4 External Common Equity 2.42

5 Straight Preferred Stock 2.22

6 Convertible Preferred 1.72

30

And the unsurprising consequences..

Aswath Damodaran

30

31

Financing Choices

Aswath Damodaran

31

¨  You are reading the Wall Street Journal and no]ce a tombstone ad for a company, offering to sell conver]ble preferred stock. What would you hypothesize about the health of the company issuing these securi]es?

a.  Nothing b.  Healthier than the average firm c.  In much more financial trouble than the average

firm

CAPITAL STRUCTURE: FINDING THE RIGHT FINANCING MIX

You can have too much debt… or too li[le..

Aswath Damodaran 32

33

The Big Picture..

Aswath Damodaran

33



rate






The hurdle rate should reflect the riskiness of the

investment and the mix of debt and

equity used to fund it.





assets.


return depends upon

current & potential

investment opportunities.



dividends or buybacks.



maximizes firm value.

34

Pathways to the Op]mal

Aswath Damodaran

34

1.  The Cost of Capital Approach: The op]mal debt ra]o is the one that minimizes the cost of capital for a firm.

2.  The Enhanced Cost of Capital approach: The op]mal debt ra]o is the one that generates the best combina]on of (low) cost of capital and (high) opera]ng income.

3.  The Adjusted Present Value Approach: The op]mal debt ra]o is the one that maximizes the overall value of the firm.

4.  The Sector Approach: The op]mal debt ra]o is the one that brings the firm closes to its peer group in terms of financing mix.

5.  The Life Cycle Approach: The op]mal debt ra]o is the one that best suits where the firm is in its life cycle.

35

I. The Cost of Capital Approach

Aswath Damodaran

35

¨  Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital.

¨  If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized.

36

Measuring Cost of Capital

Aswath Damodaran

36

¨  Recapping our discussion of cost of capital: ¨  The cost of debt is the market interest rate that the firm has to pay on its

long term borrowing today, net of tax benefits. It will be a func]on of: (a) The long-‐term riskfree rate (b) The default spread for the company, reflec]ng its credit risk (c) The firm’s marginal tax rate

¨  The cost of equity reflects the expected return demanded by marginal equity investors. If they are diversified, only the por]on of the equity risk that cannot be diversified away (beta or betas) will be priced into the cost of equity.

¨  The cost of capital is the cost of each component weighted by its rela]ve market value.

Cost of capital = Cost of equity (E/(D+E)) + AYer-‐tax cost of debt (D/(D+E))

37

Costs of Debt & Equity

Aswath Damodaran

37

¨  An ar]cle in an Asian business magazine argued that equity was cheaper than debt, because dividend yields are much lower than interest rates on debt. Do you agree with this statement?

a.  Yes b.  No ¨  Can equity ever be cheaper than debt? a.  Yes b.  No

38

Applying Cost of Capital Approach: The Textbook Example

Aswath Damodaran

38

Assume the firm has $200 million in cash flows, expected to grow 3% a year forever.

39

The U-‐shaped Cost of Capital Graph…

Aswath Damodaran

39

40

Current Cost of Capital: Disney

¨  The beta for Disney’s stock in November 2013 was 1.0013. The T. bond rate at that ]me was 2.75%. Using an es]mated equity risk premium of 5.76%, we es]mated the cost of equity for Disney to be 8.52%:

Cost of Equity = 2.75% + 1.0013(5.76%) = 8.52% ¨  Disney’s bond ra]ng in May 2009 was A, and based on this ra]ng,

the es]mated pretax cost of debt for Disney is 3.75%. Using a marginal tax rate of 36.1, the aYer-‐tax cost of debt for Disney is 2.40%.

AYer-‐Tax Cost of Debt = 3.75% (1 – 0.361) = 2.40% ¨  The cost of capital was calculated using these costs and the

weights based on market values of equity (121,878) and debt (15.961):

Cost of capital =

Aswath Damodaran

41

Mechanics of Cost of Capital Es]ma]on

Aswath Damodaran

41

1. Es]mate the Cost of Equity at different levels of debt: ¤  Equity will become riskier -‐> Beta will increase -‐> Cost of Equity will increase.

¤  Es]ma]on will use levered beta calcula]on 2. Es]mate the Cost of Debt at different levels of debt:

¤  Default risk will go up and bond ra]ngs will go down as debt goes up -‐> Cost of Debt will increase.

¤  To es]ma]ng bond ra]ngs, we will use the interest coverage ra]o (EBIT/Interest expense)

3. Es]mate the Cost of Capital at different levels of debt 4. Calculate the effect on Firm Value and Stock Price.

42

Laying the groundwork: 1. Es]mate the unlevered beta for the firm ¨  The Regression Beta: One approach is to use the regression beta (1.25)

and then unlever, using the average debt to equity ra]o (19.44%) during the period of the regression to arrive at an unlevered beta.

Unlevered beta = = 1.25 / (1 + (1 -‐ 0.361)(0.1944))= 1.1119 ¨  The Bo/om up Beta: Alterna]vely, we can back to the source and

es]mate it from the betas of the businesses.

Aswath Damodaran

Business Revenues EV/Sales Value of Business

Propor'on of Disney

Unlevered beta Value Propor'on

Media Networks $20,356 3.27 $66,580 49.27% 1.03 $66,579.81 49.27% Parks & Resorts $14,087 3.24 $45,683 33.81% 0.70 $45,682.80 33.81% Studio Entertainment $5,979 3.05 $18,234 13.49% 1.10 $18,234.27 13.49% Consumer Products $3,555 0.83 $2,952 2.18% 0.68 $2,951.50 2.18%

Interac]ve $1,064 1.58 $1,684 1.25% 1.22 $1,683.72 1.25%

Disney Opera6ons $45,041 $135,132 100.00% 0.9239 $135,132.11 100.00%

43

2. Get Disney’s current financials…

Aswath Damodaran

44

I. Cost of Equity

Levered Beta = 0.9239 (1 + (1- .361) (D/E)) Cost of equity = 2.75% + Levered beta * 5.76%

Aswath Damodaran

45

Es]ma]ng Cost of Debt

Start with the market value of the firm = = 121,878 + $15,961 = $137,839 million D/(D+E) 0.00% 10.00% Debt to capital D/E 0.00% 11.11% D/E = 10/90 = .1111 $ Debt $0 $13,784 10% of $137,839 EBITDA $12,517 $12,517 Same as 0% debt Deprecia]on $ 2,485 $ 2,485 Same as 0% debt EBIT $10,032 $10,032 Same as 0% debt Interest $0 $434 Pre-‐tax cost of debt * $ Debt Pre-‐tax Int. cov ∞ 23.10 EBIT/ Interest Expenses Likely Ra]ng AAA AAA From Ra]ngs table Pre-‐tax cost of debt 3.15% 3.15% Riskless Rate + Spread

Aswath Damodaran

46

The Ra]ngs Table

T.Bond rate =2.75%

Aswath Damodaran

Interest coverage ratio is Rating is Spread is Interest rate > 8.50 Aaa/AAA 0.40% 3.15%

6.5 – 8.5 Aa2/AA 0.70% 3.45% 5.5 – 6.5 A1/A+ 0.85% 3.60% 4.25 – 5.5 A2/A 1.00% 3.75% 3 – 4.25 A3/A- 1.30% 4.05% 2.5 -3 Baa2/BBB 2.00% 4.75%

2.25 –2.5 Ba1/BB+ 3.00% 5.75% 2 – 2.25 Ba2/BB 4.00% 6.75% 1.75 -2 B1/B+ 5.50% 8.25%

1.5 – 1.75 B2/B 6.50% 9.25% 1.25 -1.5 B3/B- 7.25% 10.00% 0.8 -1.25 Caa/CCC 8.75% 11.50% 0.65 – 0.8 Ca2/CC 9.50% 12.25% 0.2 – 0.65 C2/C 10.50% 13.25%

<0.2 D2/D 12.00% 14.75%

47

A Test: Can you do the 30% level?

Aswath Damodaran

Iteration 1

(Debt @AAA rate) Iteration 2

(Debt @AA rate) D/(D + E) 20.00% 30.00% 30.00% D/E 25.00% $ Debt $27,568 EBITDA $12,517 Depreciation $2,485 EBIT $10,032 Interest expense $868 Interest coverage ratio 11.55 Likely rating AAA Pretax cost of debt 3.15%

48

Bond Ra]ngs, Cost of Debt and Debt Ra]os

Aswath Damodaran

49

Stated versus Effec]ve Tax Rates

¨  You need taxable income for interest to provide a tax savings. Note that the EBIT at Disney is $10,032 million. As long as interest expenses are less than $10,032 million, interest expenses remain fully tax-‐deduc]ble and earn the 36.1% tax benefit. At an 60% debt ra]o, the interest expenses are $9,511 million and the tax benefit is therefore 36.1% of this amount.

¨  At a 70% debt ra]o, however, the interest expenses balloon to $11,096 million, which is greater than the EBIT of $10,032 million. We consider the tax benefit on the interest expenses up to this amount: ¤  Maximum Tax Benefit = EBIT * Marginal Tax Rate = $10,032 million * 0.361

= $ 3,622 million ¤  Adjusted Marginal Tax Rate = Maximum Tax Benefit/Interest Expenses =

$3,622/$11,096 = 32.64%

Aswath Damodaran

50

Disney’s cost of capital schedule…

Aswath Damodaran

51

Disney: Cost of Capital Chart

Aswath Damodaran

!

52

Disney: Cost of Capital Chart: 1997

Aswath Damodaran

52

10.50%&

11.00%&

11.50%&

12.00%&

12.50%&

13.00%&

13.50%&

14.00%&0.00%&

10.00%

&

20.00%

&

30.00%

&

40.00%

&

50.00%

&

60.00%

&

70.00%

&

80.00%

&

90.00%

&

Cost%of%C

apita

l%

Debt%Ra/o%

Note the kink in the cost of capital graph at 60% debt. What is causing it?

53

The cost of capital approach suggests that Disney should do the following…

¨  Disney currently has $15.96 billion in debt. The op]mal dollar debt (at 40%) is roughly $55.1 billion. Disney has excess debt capacity of 39.14 billion.

¨  To move to its op]mal and gain the increase in value, Disney should borrow $ 39.14 billion and buy back stock.

¨  Given the magnitude of this decision, you should expect to answer three ques]ons: ¤  Why should we do it? ¤  What if something goes wrong? ¤  What if we don’t want (or cannot ) buy back stock and want to make investments with the addi]onal debt capacity?

Aswath Damodaran

54

Why should we do it? Effect on Firm Value – Full Valua]on Step 1: Es]mate the cash flows to Disney as a firm

EBIT (1 – Tax Rate) = 10,032 (1 – 0.361) = $6,410 + Deprecia]on and amor]za]on = $2,485 – Capital expenditures = $5,239 – Change in noncash working capital $0 Free cash flow to the firm = $3,657

¨  Step 2: Back out the implied growth rate in the current market value Current enterprise value = $121,878 + 15,961 -‐ 3,931 = 133,908 Value of firm = $ 133,908 =

Growth rate = (Firm Value * Cost of Capital – CF to Firm)/(Firm Value + CF to Firm)

= (133,908* 0.0781 – 3,657)/(133,908+ 3,657) = 0.0494 or 4.94% ¨  Step 3: Revalue the firm with the new cost of capital

¤  Firm value =

¤  Increase in firm value = $172,935 -‐ $133,908 = $39,027 million

FCFF0 (1+g)(Cost of Capital -g)

=3, 657(1+g)(.0781 -g)

FCFF0 (1+g)(Cost of Capital -g)

=3, 657(1.0494)

(.0716 -0.0484)= $172, 935 million

Aswath Damodaran

55

Effect on Value: Incremental approach

¨  In this approach, we start with the current market value and isolate the effect of changing the capital structure on the cash flow and the resul]ng value. Enterprise Value before the change = $133,908 million Cost of financing Disney at exis]ng debt ra]o = $ 133,908 * 0.0781 = $10,458 million Cost of financing Disney at op]mal debt ra]o = $ 133,908 * 0.0716 = $ 9,592 million Annual savings in cost of financing = $10,458 million – $9,592 million = $866 million

Enterprise value aYer recapitaliza]on = Exis]ng enterprise value + PV of Savings = $133,908 + $19,623 = $153,531 million

Aswath Damodaran

Increase in Value= Annual Savings next year(Cost of Capital - g)

=$866

(0.0716 - 0.0275)= $19, 623 million

56

From firm value to value per share: The Ra]onal Investor Solu]on

¨  Because the increase in value accrues en]rely to stockholders, we can es]mate the increase in value per share by dividing by the total number of shares outstanding (1,800 million). ¤  Increase in Value per Share = $19,623/1800 = $ 10.90 ¤  New Stock Price = $67.71 + $10.90= $78.61

¨  Implicit in this computa]on is the assump]on that the increase in firm value will be spread evenly across both the stockholders who sell their stock back to the firm and those who do not and that is why we term this the “ra]onal” solu]on, since it leaves investors indifferent between selling back their shares and holding on to them.

Aswath Damodaran

57

The more general solu]on, given a buyback price ¨  Start with the buyback price and compute the number of

shares outstanding aYer the buyback: ¤  Increase in Debt = Debt at op]mal – Current Debt ¤  # Shares aYer buyback = # Shares before –

¨  Then compute the equity value aYer the recapitaliza]on, star]ng with the enterprise value at the op]mal, adding back cash and subtrac]ng out the debt at the op]mal: ¤  Equity value aYer buyback = Op]mal Enterprise value + Cash – Debt

¨  Divide the equity value aYer the buyback by the post-‐buyback number of shares. ¤  Value per share aYer buyback = Equity value aYer buyback/ Number of

shares aYer buyback

Aswath Damodaran

Increase in DebtShare Price

58

Let’s try a price: What if can buy shares back at the old price ($67.71)?

¨  Start with the buyback price and compute the number of shares outstanding aYer the buyback ¤  Debt issued = $ 55,136 -‐ $15,961 = $39,175 million ¤  # Shares aYer buyback = 1800 -‐ $39,175/$67.71 = 1221.43 m

¨  Then compute the equity value aYer the recapitaliza]on, star]ng with the enterprise value at the op]mal, adding back cash and subtrac]ng out the debt at the op]mal: ¤  Op]mal Enterprise Value = $153,531 ¤  Equity value aYer buyback = $153,531 + $3,931– $55,136 = $102,326

¨  Divide the equity value aYer the buyback by the post-‐buyback number of shares. ¤  Value per share aYer buyback = $102,326/1221.43 = $83.78

Aswath Damodaran

59

Back to the ra]onal price ($78.61): Here is the proof

¨  Start with the buyback price and compute the number of shares outstanding aYer the buyback ¤  # Shares aYer buyback = 1800 -‐ $39,175/$78.61 = 1301.65 m

¨  Then compute the equity value aYer the recapitaliza]on, star]ng with the enterprise value at the op]mal, adding back cash and subtrac]ng out the debt at the op]mal: ¤  Op]mal Enterprise Value = $153,531 ¤  Equity value aYer buyback = $153,531 + $3,931– $55,136 = $102,326

¨  Divide the equity value aYer the buyback by the post-‐buyback number of shares. ¤  Value per share aYer buyback = $102,326/1301.65 = $78.61

Aswath Damodaran

60

2. What if something goes wrong? The Downside Risk

Aswath Damodaran

60

¨  Sensi]vity to Assump]ons A. “What if” analysis

The op]mal debt ra]o is a func]on of our inputs on opera]ng income, tax rates and macro variables. We could focus on one or two key variables – opera]ng income is an obvious choice – and look at history for guidance on vola]lity in that number and ask what if ques]ons. B. “Economic Scenario” Approach

We can develop possible scenarios, based upon macro variables, and examine the op]mal debt ra]o under each one. For instance, we could look at the op]mal debt ra]o for a cyclical firm under a boom economy, a regular economy and an economy in recession.

¨  Constraint on Bond Ra]ngs/ Book Debt Ra]os Alterna]vely, we can put constraints on the op]mal debt ra]o to reduce exposure to downside risk. Thus, we could require the firm to have a minimum ra]ng, at the op]mal debt ra]o or to have a book debt ra]o that is less than a “specified” value.

61

Disney’s Opera]ng Income: History

Aswath Damodaran

Recession Decline in Operating Income 2009 Drop of 23.06% 2002 Drop of 15.82% 1991 Drop of 22.00% 1981-82 Increased by 12% Worst Year Drop of 29.47%

Standard deviation in % change in EBIT = 19.17%

62

Disney: Safety Buffers?

Aswath Damodaran

63

Constraints on Ra]ngs

¨  Management oYen specifies a 'desired ra]ng' below which they do not want to fall.

¨  The ra]ng constraint is driven by three factors ¤  it is one way of protec]ng against downside risk in opera]ng income (so do not do both)

¤  a drop in ra]ngs might affect opera]ng income ¤  there is an ego factor associated with high ra]ngs

¨  Caveat: Every ra]ng constraint has a cost. ¤  The cost of a ra]ng constraint is the difference between the unconstrained value and the value of the firm with the constraint.

¤  Managers need to be made aware of the costs of the constraints they impose.

Aswath Damodaran

64

Ra]ngs Constraints for Disney

¨  At its op]mal debt ra]o of 40%, Disney has an es]mated ra]ng of A.

¨  If managers insisted on a AA ra]ng, the op]mal debt ra]o for Disney is then 30% and the cost of the ra]ngs constraint is fairly small: Cost of AA Ra]ng Constraint = Value at 40% Debt – Value at 30% Debt = $153,531 m – $147,835 m = $ 5,696 million

¨  If managers insisted on a AAA ra]ng, the op]mal debt ra]o would drop to 20% and the cost of the ra]ngs constraint would rise: Cost of AAA ra]ng constraint = Value at 40% Debt – Value at 20% Debt = $153,531 m – $141,406 m = $ 12,125 million

Aswath Damodaran

65

3. What if you do not buy back stock..

Aswath Damodaran

65

¨  The op]mal debt ra]o is ul]mately a func]on of the underlying riskiness of the business in which you operate and your tax rate.

¨  Will the op]mal be different if you invested in projects instead of buying back stock? ¤ No. As long as the projects financed are in the same business mix that the company has always been in and your tax rate does not change significantly.

¤  Yes, if the projects are in en]rely different types of businesses or if the tax rate is significantly different.

66

Extension to a family group company: Tata Motor’s Op]mal Capital Structure

Tata Motors looks like it is over levered (29% actual versus 20% optimal), perhaps because it is drawing on the debt capacity of other companies in the Tata Group.

Aswath Damodaran

67

Extension to a firm with vola]le earnings: Vale’s Op]mal Debt Ra]o

Aswath Damodaran

Replacing Vale’s current operating income with the average over the last three years pushes up the optimal to 50%.

68

Op]mal Debt Ra]o for a young, growth firm: Baidu

Aswath Damodaran

The optimal debt ratio for Baidu is between 0 and 10%, close to its current debt ratio of 5.23%, and much lower than the optimal debt ratios computed for Disney, Vale and Tata Motors.

69

Extension to a private business Op]mal Debt Ra]o for Bookscape

Aswath Damodaran

The firm value is maximized (and the cost of capital is minimized) at a debt ratio of 30%. At its existing debt ratio of 27.81%, Bookscape is at its optimal.

Debt value of leases = $12,136 million (only debt) Estimated market value of equity = Net Income * Average PE for Publicly Traded Book Retailers = 1.575 * 20 = $31.5 million Debt ratio = 12,136/(12,136+31,500) = 27.81%

70

Limita]ons of the Cost of Capital approach

Aswath Damodaran

70

¨  It is sta]c: The most cri]cal number in the en]re analysis is the opera]ng income. If that changes, the op]mal debt ra]o will change.

¨  It ignores indirect bankruptcy costs: The opera]ng income is assumed to stay fixed as the debt ra]o and the ra]ng changes.

¨  Beta and Ra]ngs: It is based upon rigid assump]ons of how market risk and default risk get borne as the firm borrows more money and the resul]ng costs.

71

II. Enhanced Cost of Capital Approach

Aswath Damodaran

71

¨  Distress cost affected opera]ng income: In the enhanced cost of capital approach, the indirect costs of bankruptcy are built into the expected opera]ng income. As the ra]ng of the firm declines, the opera]ng income is adjusted to reflect the loss in opera]ng income that will occur when customers, suppliers and investors react.

¨  Dynamic analysis: Rather than look at a single number for opera]ng income, you can draw from a distribu]on of opera]ng income (thus allowing for different outcomes).

72

Es]ma]ng the Distress Effect-‐ Disney

Aswath Damodaran

72

Rating Drop in EBITDA (Low)

Drop in EBITDA (Medium)

Drop in EBITDA (High)

To A No effect No effect 2.00% To A- No effect 2.00% 5.00% To BBB 5.00% 10.00% 15.00% To BB+ 10.00% 20.00% 25.00% To B- 15.00% 25.00% 30.00% To C 25.00% 40.00% 50.00% To D 30.00% 50.00% 100.00%

73

The Op]mal Debt Ra]o with Indirect Bankruptcy Costs

Aswath Damodaran

73

The optimal debt ratio stays at 40% but the cliff becomes much steeper.

Debt Ratio Beta Cost of Equity

Bond Rating

Interest rate on debt Tax Rate

Cost of Debt (after-tax) WACC

Enterprise Value

0% 0.9239 8.07% Aaa/AAA 3.15% 36.10% 2.01% 8.07% $122,633 10% 0.9895 8.45% Aaa/AAA 3.15% 36.10% 2.01% 7.81% $134,020 20% 1.0715 8.92% Aaa/AAA 3.15% 36.10% 2.01% 7.54% $147,739 30% 1.1769 9.53% Aa2/AA 3.45% 36.10% 2.20% 7.33% $160,625 40% 1.3175 10.34% A2/A 3.75% 36.10% 2.40% 7.16% $172,933 50% 1.5573 11.72% C2/C 11.50% 31.44% 7.88% 9.80% $35,782 60% 1.9946 14.24% Caa/CCC 13.25% 22.74% 10.24% 11.84% $25,219 70% 2.6594 18.07% Caa/CCC 13.25% 19.49% 10.67% 12.89% $21,886 80% 3.9892 25.73% Caa/CCC 13.25% 17.05% 10.99% 13.94% $19,331 90% 7.9783 48.72% Caa/CCC 13.25% 15.16% 11.24% 14.99% $17,311

74

Extending this approach to analyzing Financial Service Firms

Aswath Damodaran

74

¨  Interest coverage ra]o spreads, which are cri]cal in determining the bond ra]ngs, have to be es]mated separately for financial service firms; applying manufacturing company spreads will result in absurdly low ra]ngs for even the safest banks and very low op]mal debt ra]os.

¨  It is difficult to es]mate the debt on a financial service company’s balance sheet. Given the mix of deposits, repurchase agreements, short-‐term financing, and other liabili]es that may appear on a financial service firm’s balance sheet, one solu]on is to focus only on long-‐term debt, defined ]ghtly, and to use interest coverage ra]os defined using only long-‐term interest expenses.

¨  Financial service firms are regulated and have to meet capital ra]os that are defined in terms of book value. If, in the process of moving to an op]mal market value debt ra]o, these firms violate the book capital ra]os, they could put themselves in jeopardy.

75

Capital Structure for a bank: A Regulatory Capital Approach ¨  Consider a bank with $ 100 million in loans outstanding and a book value of

equity of $ 6 million. Furthermore, assume that the regulatory requirement is that equity capital be maintained at 5% of loans outstanding. Finally, assume that this bank wants to increase its loan base by $ 50 million to $ 150 million and to augment its equity capital ra]o to 7% of loans outstanding. Loans outstanding aYer Expansion = $ 150 million Equity aYer expansion = 7% of $150 = $10.5 million Exis]ng Equity = $ 6.0 million New Equity needed = $ 4.5 million

¨  Your need for “external” equity as a bank/financial service company will depend upon

a.  Your growth rate: Higher growth -‐> More external equity b.  Exis]ng capitaliza]on vs Target capitaliza]on: Under capitalized -‐> More

external equity c.  Current earnings: Less earnings -‐> More external equity d.  Current dividends: More dividends -‐> More external equity

Aswath Damodaran

76

Deutsche Bank’s Financial Mix

Current 1 2 3 4 5 Asset Base 439,851 € 453,047 € 466,638 € 480,637 € 495,056 € 509,908 € Capital ratio 15.13% 15.71% 16.28% 16.85% 17.43% 18.00% Tier 1 Capital 66,561 € 71,156 € 75,967 € 81,002 € 86,271 € 91,783 € Change in regulatory capital 4,595 € 4,811 € 5,035 € 5,269 € 5,512 € Book Equity 76,829 € 81,424 € 86,235 € 91,270 € 96,539 € 102,051 € ROE -1.08% 0.74% 2.55% 4.37% 6.18% 8.00% Net Income -716 € 602 € 2,203 € 3,988 € 5,971 € 8,164 € - Investment in Regulatory Capital 4,595 € 4,811 € 5,035 € 5,269 € 5,512 € FCFE -3,993 € -2,608 € -1,047 € 702 € 2,652 €

Aswath Damodaran

76

The cumulative FCFE over the next 5 years is -4,294 million Euros. Clearly, it does not make the sense to pay dividends or buy back stock.

77

Financing Strategies for a financial ins]tu]on

Aswath Damodaran

77

¨  The Regulatory minimum strategy: In this strategy, financial service firms try to stay with the bare minimum equity capital, as required by the regulatory ra]os. In the most aggressive versions of this strategy, firms exploit loopholes in the regulatory framework to invest in those businesses where regulatory capital ra]os are set too low (rela]ve to the risk of these businesses).

¨  The Self-‐regulatory strategy: The objec]ve for a bank raising equity is not to meet regulatory capital ra]os but to ensure that losses from the business can be covered by the exis]ng equity. In effect, financial service firms can assess how much equity they need to hold by evalua]ng the riskiness of their businesses and the poten]al for losses.

¨  Combina]on strategy: In this strategy, the regulatory capital ra]os operate as a floor for established businesses, with the firm adding buffers for safety where needed..

78

Determinants of the Op]mal Debt Ra]o: 1. The marginal tax rate

Aswath Damodaran

78

¨  The primary benefit of debt is a tax benefit. The higher the marginal tax rate, the greater the benefit to borrowing:

79

2. Pre-‐tax Cash flow Return

Aswath Damodaran

79

Company EBITDA EBIT Enterprise Value EBITDA/EV EBIT/EV

Optimal Debt

Optimal Debt Ratio

Disney $12,517 $10,032 $133,908 9.35% 7.49% $55,136 40.00% Vale $20,167 $15,667 $112,352 17.95% 13.94% $35,845 30.00% Tata Motors 250,116₹ 166,605₹ 1,427,478₹ 17.52% 11.67% 325,986₹ 20.00% Baidu ¥13,073 ¥10,887 ¥342,269 3.82% 3.18% ¥35,280 10.00% Bookscape $4,150 $2,536 $42,636 9.73% 5.95% $13,091 30.00%

Higher cash flows, as a percent of value, give you a higher debt capacity, though less so in emerging markets with substantial country risk.

80

3. Opera]ng Risk

Aswath Damodaran

80

¨  Firms that face more risk or uncertainty in their opera]ons (and more variable opera]ng income as a consequence) will have lower op]mal debt ra]os than firms that have more predictable opera]ons.

¨  Opera]ng risk enters the cost of capital approach in two places: ¤  Unlevered beta: Firms that face more opera]ng risk will tend to have higher unlevered betas. As they borrow, debt will magnify this already large risk and push up costs of equity much more steeply.

¤  Bond ra]ngs: For any given level of opera]ng income, firms that face more risk in opera]ons will have lower ra]ngs. The ra]ngs are based upon normalized income.

81

4. The only macro determinant: Equity vs Debt Risk Premiums

Aswath Damodaran

81

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

ERP

/ Baa

Spr

ead

Pre

miu

m (

Sp

read

)

Figure 16: Equity Risk Premiums and Bond Default Spreads

ERP/Baa Spread Baa - T.Bond Rate ERP

82

6 Applica]on Test: Your firm’s op]mal financing mix

Aswath Damodaran

82

¨  Using the op]mal capital structure spreadsheet provided: 1.  Es]mate the op]mal debt ra]o for your firm 2.  Es]mate the new cost of capital at the op]mal 3.  Es]mate the effect of the change in the cost of capital on

firm value 4.  Es]mate the effect on the stock price

¨  In terms of the mechanics, what would you need to do to get to the op]mal immediately?

83

III. The APV Approach to Op]mal Capital Structure

Aswath Damodaran

83

¨  In the adjusted present value approach, the value of the firm is wri[en as the sum of the value of the firm without debt (the unlevered firm) and the effect of debt on firm value Firm Value = Unlevered Firm Value + (Tax Benefits of Debt -‐

Expected Bankruptcy Cost from the Debt)

¨  The op]mal dollar debt level is the one that maximizes firm value

84

Implemen]ng the APV Approach

Aswath Damodaran

84

¨  Step 1: Es]mate the unlevered firm value. This can be done in one of two ways: ¤  Es]ma]ng the unlevered beta, a cost of equity based upon the unlevered

beta and valuing the firm using this cost of equity (which will also be the cost of capital, with an unlevered firm)

¤  Alterna]vely, Unlevered Firm Value = Current Market Value of Firm -‐ Tax Benefits of Debt (Current) + Expected Bankruptcy cost from Debt

¨  Step 2: Es]mate the tax benefits at different levels of debt. The simplest assump]on to make is that the savings are perpetual, in which case ¤  Tax benefits = Dollar Debt * Tax Rate

¨  Step 3: Es]mate a probability of bankruptcy at each debt level, and mul]ply by the cost of bankruptcy (including both direct and indirect costs) to es]mate the expected bankruptcy cost.

85

Es]ma]ng Expected Bankruptcy Cost

Aswath Damodaran

85

¨  Probability of Bankruptcy ¤  Es]mate the synthe]c ra]ng that the firm will have at each level of

debt ¤  Es]mate the probability that the firm will go bankrupt over ]me, at

that level of debt (Use studies that have es]mated the empirical probabili]es of this occurring over ]me -‐ Altman does an update every year)

¨  Cost of Bankruptcy ¤  The direct bankruptcy cost is the easier component. It is generally

between 5-‐10% of firm value, based upon empirical studies ¤  The indirect bankruptcy cost is much tougher. It should be higher for

sectors where opera]ng income is affected significantly by default risk (like airlines) and lower for sectors where it is not (like groceries)

86

Ra]ngs and Default Probabili]es: Results from Altman study of bonds

Aswath Damodaran

86

Ra]ng Likelihood of Default AAA 0.07% AA 0.51% A+ 0.60% A 0.66% A-‐ 2.50% BBB 7.54% BB 16.63% B+ 25.00% B 36.80% B-‐ 45.00% CCC 59.01% CC 70.00% C 85.00% D 100.00%

Altman estimated these probabilities by looking at bonds in each ratings class ten years prior and then examining the proportion of these bonds that defaulted over the ten years.

87

Disney: Es]ma]ng Unlevered Firm Value

Aswath Damodaran

87

Current Value of firm = $121,878+ $15,961 = $ 137,839 -‐ Tax Benefit on Current Debt = $15,961 * 0.361 = $ 5,762 + Expected Bankruptcy Cost = 0.66% * (0.25 * 137,839) = $ 227 Unlevered Value of Firm = = $ 132,304

¤  Cost of Bankruptcy for Disney = 25% of firm value ¤  Probability of Bankruptcy = 0.66%, based on firm’s current ra]ng of A

¤  Tax Rate = 36.1%

88

Disney: APV at Debt Ra]os

Aswath Damodaran

88

The optimal debt ratio is 40%, which is the point at which firm value is maximized.

Debt Ratio $ Debt Tax Rate Unlevered Firm Value Tax Benefits Bond Rating

Probability of Default

Expected Bankruptcy

Cost

Value of Levered

Firm 0% $0 36.10% $132,304 $0 AAA 0.07% $23 $132,281 10% $13,784 36.10% $132,304 $4,976 Aaa/AAA 0.07% $24 $137,256 20% $27,568 36.10% $132,304 $9,952 Aaa/AAA 0.07% $25 $142,231 30% $41,352 36.10% $132,304 $14,928 Aa2/AA 0.51% $188 $147,045 40% $55,136 36.10% $132,304 $19,904 A2/A 0.66% $251 $151,957 50% $68,919 36.10% $132,304 $24,880 B3/B- 45.00% $17,683 $139,501 60% $82,703 36.10% $132,304 $29,856 C2/C 59.01% $23,923 $138,238 70% $96,487 32.64% $132,304 $31,491 C2/C 59.01% $24,164 $139,631 80% $110,271 26.81% $132,304 $29,563 Ca2/CC 70.00% $28,327 $133,540 90% $124,055 22.03% $132,304 $27,332 Caa/CCC 85.00% $33,923 $125,713

89

IV. Rela]ve Analysis

Aswath Damodaran

89

¨  The “safest” place for any firm to be is close to the industry average

¨  Subjec]ve adjustments can be made to these averages to arrive at the right debt ra]o. ¤ Higher tax rates -‐> Higher debt ra]os (Tax benefits) ¤  Lower insider ownership -‐> Higher debt ra]os (Greater discipline)

¤ More stable income -‐> Higher debt ra]os (Lower bankruptcy costs)

¤ More intangible assets -‐> Lower debt ra]os (More agency problems)

90

Comparing to industry averages

Aswath Damodaran

90

Debt to Capital Ratio

Net Debt to Capital Ratio Debt to Capital

Ratio Net Debt to Capital

Ratio

Company Book value

Market value

Book value

Market value

Comparable group

Book value

Market value

Book value

Market value

Disney 22.88% 11.58% 17.70% 8.98% US Entertainment 39.03% 15.44% 24.92% 9.93%

Vale 39.02% 35.48% 34.90% 31.38%

Global Diversified Mining & Iron Ore (Market cap> $1 b)

34.43% 26.03% 26.01% 17.90%

Tata Motors 58.51% 29.28% 22.44% 19.25%

Global Autos (Market Cap> $1 b)

35.96% 18.72% 3.53% 0.17%

Baidu 32.93% 5.23% 20.12% 2.32% Global Online Advertising 6.37% 1.83% -27.13% -2.76%

91

Geong past simple averages

Aswath Damodaran

91

Step 1: Run a regression of debt ra]os on the variables that you believe determine debt ra]os in the sector. For example,

Debt Ra]o = a + b (Tax rate) + c (Earnings Variability) + d (EBITDA/Firm Value)

Check this regression for sta]s]cal significance (t sta]s]cs) and predic]ve ability (R squared) Step 2: Es]mate the values of the proxies for the firm under considera]on. Plugging into the cross sec]onal regression, we can obtain an es]mate of predicted debt ra]o. Step 3: Compare the actual debt ra]o to the predicted debt ra]o.

92

Applying the Regression Methodology: Global Auto Firms

Aswath Damodaran

92

¨  Using a sample of 56 global auto firms, we arrived at the following regression:

Debt to capital = 0.09 + 0.63 (Effec]ve Tax Rate) + 1.01 (EBITDA/ Enterprise Value) -‐ 0.93 (Cap Ex/ Enterprise Value) ¨  The R squared of the regression is 21%. This regression can be used to arrive at a predicted value for Tata Motors of:

Predicted Debt Ra]o = 0.09 + 0.63 (0.252) +1.01 (0.1167) -‐ 0.93 (0.1949) = .1854 or 18.54% ¨  Based upon the capital structure of other firms in the automobile industry, Tata Motors should have a market value debt ra]o of 18.54%. It is over levered at its exis]ng debt ra]o of 29.28%.

93

Extending to the en]re market

Aswath Damodaran

93

¨  Using 2014 data for US listed firms, we looked at the determinants of the market debt to capital ra]o. The regression provides the following results –

DFR = 0.27 -‐ 0.24 ETR -‐0.10 g– 0.065 INST -‐0.338 CVOI+ 0.59 E/V

(15.79) (9.00) (2.71) (3.55) (3.10) (6.85)

DFR = Debt / ( Debt + Market Value of Equity) ETR = Effec]ve tax rate in most recent twelve months INST = % of Shares held by ins]tu]ons CVOI = Std dev in OI in last 10 years/ Average OI in last 10 years E/V = EBITDA/ (Market Value of Equity + Debt-‐ Cash)

The regression has an R-‐squared of 8%.

94

Applying the Regression

Aswath Damodaran

94

¨  Disney had the following values for these inputs in 2008. Es]mate the op]mal debt ra]o using the debt regression. ETR = 31.02% Expected Revenue Growth = 6.45% INST = 70.2% CVOI = 0.0296 E/V = 9.35%

Op]mal Debt Ra]o = 0.27 -‐ 0.24 (.3102) -‐0.10 (.0645)– 0.065 (.702) -‐0.338 (.0296)+ 0.59 (.0935) = 0.1886 or 18.86%% ¨  What does this op]mal debt ra]o tell you?

¨  Why might it be different from the op]mal calculated using the weighted average cost of capital?

95

Summarizing the op]mal debt ra]os…

Aswath Damodaran

95

Disney Vale Tata Motors Baidu

Actual Debt Ratio 11.58% 35.48% 29.28% 5.23%

Optimal

I. Operating income 35.00% — -

II. Standard Cost of capital 40.00% 30.00% (actual)

50.00% (normalized)

20.00% 10.00%

III. Enhanced Cost of Capital 40.00% 30.00% (actual)

40.00% (normalized)

10.00% 10.00%

IV. APV 40.00% 30.00% 20.00% 20.00%

V. Comparable

To industry 28.54% 26.03% 18.72% 1.83%

To market 23.14% — -

GETTING TO THE OPTIMAL: TIMING AND FINANCING CHOICES

You can take it slow.. Or perhaps not…

Aswath Damodaran 96

97

Big Picture…

Aswath Damodaran

97



rate













assets.


return depends upon

current & potential








98

Now that we have an op]mal.. And an actual.. What next?

Aswath Damodaran

98

¨  At the end of the analysis of financing mix (using whatever tool or tools you choose to use), you can come to one of three conclusions: 1.  The firm has the right financing mix 2.  It has too li[le debt (it is under levered) 3.  It has too much debt (it is over levered)

¨  The next step in the process is ¤ Deciding how much quickly or gradually the firm should move to its op]mal

¤  Assuming that it does, the right kind of financing to use in making this adjustment

99

A Framework for Geong to the Op]mal

Aswath Damodaran

99

Is the actual debt ratio greater than or lesser than the optimal debt ratio?"

Actual > Optimal"Overlevered"

Actual < Optimal"Underlevered"

Is the firm under bankruptcy threat?" Is the firm a takeover target?"

Yes" No"

Reduce Debt quickly"1. Equity for Debt swap"2. Sell Assets; use cash"to pay off debt"3. Renegotiate with lenders"

Does the firm have good "projects?"ROE > Cost of Equity"ROC > Cost of Capital"

Yes"Take good projects with"new equity or with retained"earnings."

No"1. Pay off debt with retained"earnings."2. Reduce or eliminate dividends."3. Issue new equity and pay off "debt."

Yes" No"


Yes"Take good projects with"debt."

No"

Do your stockholders like"dividends?"

Yes"Pay Dividends" No"

Buy back stock"

Increase leverage"quickly"1. Debt/Equity swaps"2. Borrow money&"buy shares."

100

Disney: Applying the Framework

Is the actual debt ratio greater than or lesser than the optimal debt ratio?"

Actual > Optimal"Overlevered"

Actual < Optimal!Actual (11.58%) < Optimal (40%)!

Is the firm under bankruptcy threat?" Is the firm a takeover target?"

Yes" No"

Reduce Debt quickly"1. Equity for Debt swap"2. Sell Assets; use cash"to pay off debt"3. Renegotiate with lenders"


Yes"Take good projects with"new equity or with retained"earnings."

No"1. Pay off debt with retained"earnings."2. Reduce or eliminate dividends."3. Issue new equity and pay off "debt."

Yes" No. Large mkt cap & positive Jensen’s α!


Yes. ROC > Cost of capital"Take good projects!With debt.!

No"

Do your stockholders like"dividends?"

Yes"Pay Dividends" No"

Buy back stock"

Increase leverage"quickly"1. Debt/Equity swaps"2. Borrow money&"buy shares."

101

6 Applica]on Test: Geong to the Op]mal

Aswath Damodaran

101

¨  Based upon your analysis of both the firm’s capital structure and investment record, what path would you map out for the firm?

a.  Immediate change in leverage b.  Gradual change in leverage c.  No change in leverage ¨  Would you recommend that the firm change its financing mix by

a.  Paying off debt/Buying back equity b.  Take projects with equity/debt

102

The Mechanics of Changing Debt Ra]o quickly…

Aswath Damodaran

102

Assets Liabilities

Opearing Assets in place

Debt

EquityGrowth Assets

Cash

To decrease the debt ratio

To increase the debt ratio

Borrow money and buy back stock or pay a large special dividend

Sell operating assets and use cash to buy back stock or pay or special dividend

Issue new stock to retire debt or get debt holders to accept equity in the firm.

Sell operating assets and use cash to pay down debt.

103

The mechanics of changing debt ra]os over ]me… gradually…

Aswath Damodaran

103

¨  To change debt ra]os over ]me, you use the same mix of tools that you used to change debt ra]os gradually: ¤  Dividends and stock buybacks: Dividends and stock buybacks will reduce the value of equity.

¤  Debt repayments: will reduce the value of debt. ¨  The complica]on of changing debt ra]os over ]me is that firm value is itself a moving target. ¤  If equity is fairly valued today, the equity value should change over ]me to reflect the expected price apprecia]on:

¤  Expected Price apprecia]on = Cost of equity – Dividend Yield ¤  Debt will also change over ]me, in conjunc]on as firm value changes.

104

Designing Debt: The Fundamental Principle

Aswath Damodaran

104

¨  The objec]ve in designing debt is to make the cash flows on debt match up as closely as possible with the cash flows that the firm makes on its assets.

¨  By doing so, we reduce our risk of default, increase debt capacity and increase firm value.

105

Firm with mismatched debt

Aswath Damodaran

105

Firm Value

Value of Debt

106

Firm with matched Debt

Aswath Damodaran

106

Firm Value

Value of Debt

107

Design the perfect financing instrument

Aswath Damodaran

107

¨  The perfect financing instrument will ¤ Have all of the tax advantages of debt ¤ While preserving the flexibility offered by equity

Duration Currency Effect of InflationUncertainty about Future

Growth PatternsCyclicality &Other Effects

Define DebtCharacteristics

Duration/Maturity

CurrencyMix

Fixed vs. Floating Rate* More floating rate - if CF move with inflation- with greater uncertainty on future

Straight versusConvertible- Convertible ifcash flows low now but highexp. growth

Special Featureson Debt- Options to make cash flows on debt match cash flows on assets

Start with the Cash Flowson Assets/Projects

Commodity BondsCatastrophe Notes

Design debt to have cash flows that match up to cash flows on the assets financed

108

Ensuring that you have not crossed the line drawn by the tax code

Aswath Damodaran

108

¨  All of this design work is lost, however, if the security that you have designed does not deliver the tax benefits.

¨  In addi]on, there may be a trade off between mismatching debt and geong greater tax benefits.

Overlay taxpreferences

Deductibility of cash flowsfor tax purposes

Differences in tax ratesacross different locales

If tax advantages are large enough, you might override results of previous step

Zero Coupons

109

While keeping equity research analysts, ra]ngs agencies and regulators applauding

Aswath Damodaran

109

¨  Ra]ngs agencies want companies to issue equity, since it makes them safer.

¨  Equity research analysts want them not to issue equity because it dilutes earnings per share.

¨  Regulatory authori]es want to ensure that you meet their requirements in terms of capital ra]os (usually book value).

¨  Financing that leaves all three groups happy is nirvana.

Consider ratings agency& analyst concerns

Analyst Concerns- Effect on EPS- Value relative to comparables

Ratings Agency- Effect on Ratios- Ratios relative to comparables

Regulatory Concerns- Measures used

Can securities be designed that can make these different entities happy?

Operating LeasesMIPsSurplus Notes

110

Debt or Equity: The Strange Case of Trust Preferred

Aswath Damodaran

110

¨  Trust preferred stock has ¤  A fixed dividend payment, specified at the ]me of the issue ¤  That is tax deduc]ble ¤  And failing to make the payment can give these shareholders vo]ng rights

¨  When trust preferred was first created, ra]ngs agencies treated it as equity. As they have become more savvy, ra]ngs agencies have started giving firms only par]al equity credit for trust preferred.

111

Debt, Equity and Quasi Equity

Aswath Damodaran

111

¨  Assuming that trust preferred stock gets treated as equity by ra]ngs agencies, which of the following firms is the most appropriate firm to be issuing it? a.  A firm that is under levered, but has a ra]ng constraint

that would be violated if it moved to its op]mal b.  A firm that is over levered that is unable to issue debt

because of the ra]ng agency concerns.

112

Soothe bondholder fears

Aswath Damodaran

112

¨  There are some firms that face skep]cism from bondholders when they go out to raise debt, because ¤ Of their past history of defaults or other ac]ons ¤  They are small firms without any borrowing history

¨  Bondholders tend to demand much higher interest rates from these firms to reflect these concerns.

Factor in agencyconflicts between stockand bond holders

Observability of Cash Flowsby Lenders- Less observable cash flows lead to more conflicts

Type of Assets financed- Tangible and liquid assets create less agency problems

Existing Debt covenants- Restrictions on Financing

If agency problems are substantial, consider issuing convertible bonds

ConvertibilesPuttable BondsRating Sensitive

NotesLYONs

113

And do not lock in market mistakes that work against you

Aswath Damodaran

113

¨  Ra]ngs agencies can some]mes under rate a firm, and markets can under price a firm’s stock or bonds. If this occurs, firms should not lock in these mistakes by issuing securi]es for the long term. In par]cular, ¤  Issuing equity or equity based products (including conver]bles), when equity is under priced transfers wealth from exis]ng stockholders to the new stockholders

¤  Issuing long term debt when a firm is under rated locks in rates at levels that are far too high, given the firm’s default risk.

¨  What is the solu]on ¤  If you need to use equity? ¤  If you need to use debt?

114

Designing Debt: Bringing it all together

Aswath Damodaran

114

Duration Currency Effect of Inflation Uncertainty about Future

Growth Patterns Cyclicality & Other Effects

Define Debt Characteristics Duration/ Maturity

Currency Mix

Fixed vs. Floating Rate * More floating rate - if CF move with inflation - with greater uncertainty on future

Straight versus Convertible - Convertible if cash flows low now but high exp. growth

Special Features on Debt - Options to make cash flows on debt match cash flows on assets

Start with the Cash Flows on Assets/ Projects

Overlay tax preferences Deductibility of cash flows for tax purposes

Differences in tax rates across different locales

Consider ratings agency & analyst concerns Analyst Concerns - Effect on EPS - Value relative to comparables

Ratings Agency - Effect on Ratios - Ratios relative to comparables

Regulatory Concerns - Measures used

Factor in agency conflicts between stock and bond holders

Observability of Cash Flows by Lenders - Less observable cash flows lead to more conflicts

Type of Assets financed - Tangible and liquid assets create less agency problems

Existing Debt covenants - Restrictions on Financing

Consider Information Asymmetries Uncertainty about Future Cashflows - When there is more uncertainty, it may be better to use short term debt

Credibility & Quality of the Firm - Firms with credibility problems will issue more short term debt

If agency problems are substantial, consider issuing convertible bonds

Can securities be designed that can make these different entities happy?

If tax advantages are large enough, you might override results of previous step

Zero Coupons

Operating Leases MIPs Surplus Notes

Convertibiles Puttable Bonds Rating Sensitive

Notes LYONs

Commodity Bonds Catastrophe Notes

Design debt to have cash flows that match up to cash flows on the assets financed

115

Approaches for evalua]ng Asset Cash Flows

Aswath Damodaran

115

I. Intui]ve Approach ¤  Are the projects typically long term or short term? What is the cash

flow pa[ern on projects? ¤  How much growth poten]al does the firm have rela]ve to current

projects? ¤  How cyclical are the cash flows? What specific factors determine the

cash flows on projects? II. Project Cash Flow Approach

¤  Es]mate expected cash flows on a typical project for the firm ¤  Do scenario analyses on these cash flows, based upon different macro

economic scenarios III. Historical Data

¤  Opera]ng Cash Flows ¤  Firm Value

116

I. Intui]ve Approach -‐ Disney

Aswath Damodaran

116

Business Project Cash Flow Characteristics Type of Financing

Studio

entertainment

Movie projects are likely to • Be short-term • Have cash outflows primarily in dollars (because Disney makes most of its

movies in the U.S.), but cash inflows could have a substantial foreign currency component (because of overseas revenues)

• Have net cash flows that are heavily driven by whether the movie is a hit, which is often difficult to predict

Debt should be 1. Short-term 2. Mixed currency debt,

reflecting audience make-up.

3. If possible, tied to the success of movies.

Media networks Projects are likely to be 1. Short-term 2. Primarily in dollars, though foreign component is growing, especially for ESPN. 3. Driven by advertising revenues and show success (Nielsen ratings)

Debt should be 1. Short-term 2. Primarily dollar debt 3. If possible, linked to

network ratings Park resorts Projects are likely to be

1. Very long-term 2. Currency will be a function of the region (rather than country) where park is

located. 3. Affected by success of studio entertainment and media networks divisions

Debt should be 1. Long-term 2. Mix of currencies, based

on tourist makeup at the park.

Consumer products

Projects are likely to be short- to medium-term and linked to the success of the movie division; most of Disney’s product offerings and licensing revenues are derived from their movie productions

Debt should be 1. Medium-term 2. Dollar debt

Interactive Projects are likely to be short-term, with high growth potential and significant risk. While cash flows will initially be primarily in US dollars, the mix of currencies will shift as the business ages.

Debt should be short-term, convertible US dollar debt.

117

6 Applica]on Test: Choosing your Financing Type

Aswath Damodaran

117

¨  Based upon the business that your firm is in, and the typical investments that it makes, what kind of financing would you expect your firm to use in terms of a.  Dura]on (long term or short term) b.  Currency c.  Fixed or Floa]ng rate d.  Straight or Conver]ble

118

II. Project Specific Financing

Aswath Damodaran

118

¨  With project specific financing, you match the financing choices to the project being funded. The benefit is that the the debt is truly customized to the project.

¨  Project specific financing makes the most sense when you have a few large, independent projects to be financed. It becomes both imprac]cal and costly when firms have por�olios of projects with interdependent cashflows.

119

Dura]on of Disney Theme Park

Aswath Damodaran

119

Duration of the Project = 62,355/3296 = 18.92 years

120

The perfect theme park debt…

Aswath Damodaran

120

¨  The perfect debt for this theme park would have a dura]on of roughly 19 years and be in a mix of La]n American currencies (since it is located in Brazil), reflec]ng where the visitors to the park are coming from.

¨  If possible, you would ]e the interest payments on the debt to the number of visitors at the park.

121

III. Firm-‐wide financing

Aswath Damodaran

121

¨  Rather than look at individual projects, you could consider the firm to be a por�olio of projects. The firm’s past history should then provide clues as to what type of debt makes the most sense.

¨  Opera]ng Cash Flows n  The ques]on of how sensi]ve a firm’s asset cash flows are to a variety of factors, such as interest rates, infla]on, currency rates and the economy, can be directly tested by regressing changes in the opera]ng income against changes in these variables.

n  This analysis is useful in determining the coupon/interest payment structure of the debt.

¨  Firm Value n  The firm value is clearly a func]on of the level of opera]ng income, but it also incorporates other factors such as expected growth & cost of capital.

n  The firm value analysis is useful in determining the overall structure of the debt, par]cularly maturity.

122

Disney: Historical Data 122

Date Operating Income Enterprise Value (V) % Chg in OI % Chg in V

2013 9450 $126,815 6.62% 21.09% 2012 8863 $104,729 13.91% 56.85% 2011 7781 $66,769 15.69% -9.19% 2010 6726 $73,524 18.06% 22.84% 2009 5697 $59,855 -23.06% -18.11% 2008 $7,404 $73,091 8.42% -6.27% 2007 $6,829 $77,980 27.53% 2.98% 2006 $5,355 $75,720 30.39% 27.80% 2005 $4,107 $59,248 1.46% 2.55% 2004 $4,048 $57,776 49.21% 9.53% 2003 $2,713 $52,747 13.80% 20.45% 2002 $2,384 $43,791 -15.82% -9.01% 2001 $2,832 $48,128 12.16% -45.53% 2000 $2,525 $88,355 -22.64% 35.67% 1999 $3,264 $65,125 -15.07% -5.91% 1998 $3,843 $69,213 -2.59% 6.20% 1997 $3,945 $65,173 30.46% 18.25% 1996 $3,024 $55,116 33.69% 77.65% 1995 $2,262 $31,025 25.39% 39.75% 1994 $1,804 $22,200 15.64% 9.04% 1993 $1,560 $20,360 21.21% 6.88% 1992 $1,287 $19,049 28.19% 23.89% 1991 $1,004 $15,376 -21.99% 26.50% 1990 $1,287 $12,155 16.05% -23.64% 1989 $1,109 $15,918 40.56% 101.93% 1988 $789 $7,883 11.60% -23.91% 1987 $707 $10,360 53.03% 83.69% 1986 $462 $5,640 25.20% 61.23% 1985 $369 $3,498 157.99% 24.37%

123

The Macroeconomic Data 123

Date Change in T.Bond rate % Chg in GDP % Change in CPI % Change in US $

2013 1.07% 1.83% 1.18% 4.89% 2012 -0.11% 2.20% -1.03% 2.75% 2011 -1.37% 1.81% 1.48% -4.59% 2010 -0.53% 2.39% 1.97% -3.64% 2009 1.29% -3.07% -3.98% 5.79% 2008 -1.44% -1.18% -4.26% 10.88% 2007 -0.65% 2.93% 2.19% -11.30% 2006 0.30% 3.40% -1.84% -2.28% 2005 0.16% 3.68% 0.66% 3.98% 2004 0.13% 3.72% 1.34% -3.92% 2003 0.05% 4.32% -0.65% -14.59% 2002 -0.97% 2.80% 1.44% -11.17% 2001 -0.18% -0.04% -2.50% 7.45% 2000 -0.98% 2.24% 0.96% 7.73% 1999 1.56% 4.70% 1.04% 1.68% 1998 -1.03% 4.51% 0.11% -4.08% 1997 -0.63% 4.33% -1.43% 9.40% 1996 0.80% 4.43% 0.31% 4.14% 1995 -2.09% 2.01% -0.08% -0.71% 1994 1.92% 4.12% 0.27% -5.37% 1993 -0.83% 2.50% -0.72% 0.56% 1992 -0.02% 4.15% 0.64% 6.89% 1991 -1.26% 1.09% -2.89% 0.69% 1990 0.12% 0.65% 0.43% -8.00% 1989 -1.11% 2.66% 0.51% 2.04% 1988 0.26% 3.66% 0.60% 1.05% 1987 1.53% 4.49% 2.54% -12.01% 1986 -1.61% 2.83% -2.33% -15.26% 1985 -2.27% 4.19% 3.89% -13.51%

124

I. Sensi]vity to Interest Rate Changes

Aswath Damodaran

124

¨  How sensi]ve is the firm’s value and opera]ng income to changes in the level of interest rates?

¨  The answer to this ques]on is important because it ¤  it provides a measure of the dura]on of the firm’s projects ¤  it provides insight into whether the firm should be using fixed or floa]ng rate debt.

125

Firm Value versus Interest Rate Changes

Aswath Damodaran

125

¨  Regressing changes in firm value against changes in interest rates over this period yields the following regression – Change in Firm Value = 0.1790 – 2.3251 (Change in Interest Rates)

(2.74) (0.39)

¤  T sta]s]cs are in brackets.

¨  The coefficient on the regression (-‐2.33) measures how much the value of Disney as a firm changes for a unit change in interest rates.

126

Why the coefficient on the regression is dura]on..

Aswath Damodaran

126

¨  The dura]on of a straight bond or loan issued by a company can be wri[en in terms of the coupons (interest payments) on the bond (loan) and the face value of the bond to be –

¨  The dura]on of a bond measures how much the price of the bond changes for a unit change in interest rates.

¨  Holding other factors constant, the dura]on of a bond will increase with the maturity of the bond, and decrease with the coupon rate on the bond.

Duration of Bond = dP/Pdr/r

=

t*Coupont

(1+r)tt=1

t=N

∑ +N*Face Value

(1+r)N

"

#$

%

&'

Coupont

(1+r)tt=1

t=N

∑ +Face Value

(1+r)N

"

#$

%

&'

127

Dura]on: Comparing Approaches

Aswath Damodaran

127

δP/δr=Percentage Change in Value for apercentage change in Interest Rates

Traditional DurationMeasures

Regression:δP = a + b (δr)

Uses:1. Projected Cash FlowsAssumes:1. Cash Flows are unaffected by changes in interest rates2. Changes in interest rates are small.

Uses:1. Historical data on changes in firm value (market) and interest ratesAssumes:1. Past project cash flows are similar to future project cash flows.2. Relationship between cash flows and interest rates is stable.3. Changes in market value reflect changes in the value of the firm.

128

Opera]ng Income versus Interest Rates

Aswath Damodaran

128

¨  Regressing changes in opera]ng cash flow against changes in interest rates over this period yields the following regression –

Change in Opera]ng Income = 0.1698 – 7.9339 (Change in Interest Rates) (2.69a) (1.40)

Conclusion: Disney’s opera]ng income has been affected a lot more than its firm value has by changes in interest rates.

129

II. Sensi]vity to Changes in GDP/ GNP

Aswath Damodaran

129

¨  How sensi]ve is the firm’s value and opera]ng income to changes in the GNP/GDP?

¨  The answer to this ques]on is important because ¤  it provides insight into whether the firm’s cash flows are cyclical and

¤  whether the cash flows on the firm’s debt should be designed to protect against cyclical factors.

¨  If the cash flows and firm value are sensi]ve to movements in the economy, the firm will either have to issue less debt overall, or add special features to the debt to ]e cash flows on the debt to the firm’s cash flows.

130

Regression Results

Aswath Damodaran

130

¨  Regressing changes in firm value against changes in the GDP over this period yields the following regression –

Change in Firm Value = 0.0067 + 6.7000 (GDP Growth) (0.06) (2.03a)

Conclusion: Disney is sensi]ve to economic growth ¨  Regressing changes in opera]ng cash flow against changes in GDP over this period yields the following regression –

Change in Opera]ng Income = 0.0142 + 6.6443 ( GDP Growth) (0.13) (2.05a)

Conclusion: Disney’s opera]ng income is sensi]ve to economic growth as well.

131

III. Sensi]vity to Currency Changes

Aswath Damodaran

131

¨  How sensi]ve is the firm’s value and opera]ng income to changes in exchange rates?

¨  The answer to this ques]on is important, because ¤  it provides a measure of how sensi]ve cash flows and firm value are to changes in the currency

¤  it provides guidance on whether the firm should issue debt in another currency that it may be exposed to.

¨  If cash flows and firm value are sensi]ve to changes in the dollar, the firm should ¤  figure out which currency its cash flows are in; ¤  and issued some debt in that currency

132

Regression Results

Aswath Damodaran

132

¨  Regressing changes in firm value against changes in the dollar over this period yields the following regression –

Change in Firm Value = 0.1774– 0.5705 (Change in Dollar) (2.76) (0.67)

Conclusion: Disney’s value is sensi]ve to exchange rate changes, decreasing as the dollar strengthens. However, the effect is sta]s]cally insignificant. ¨  Regressing changes in opera]ng cash flow against changes in the

dollar over this period yields the following regression – Change in Opera]ng Income = 0.1680 – 1.6773 (Change in Dollar)

(2.82a) (2.13a ) Conclusion: Disney’s opera]ng income is more strongly impacted by the dollar than its value is. A stronger dollar seems to hurt opera]ng income.

133

IV. Sensi]vity to Infla]on

Aswath Damodaran

133

¨  How sensi]ve is the firm’s value and opera]ng income to changes in the infla]on rate?

¨  The answer to this ques]on is important, because ¤  it provides a measure of whether cash flows are posi]vely or nega]vely impacted by infla]on.

¤  it then helps in the design of debt; whether the debt should be fixed or floa]ng rate debt.

¨  If cash flows move with infla]on, increasing (decreasing) as infla]on increases (decreases), the debt should have a larger floa]ng rate component.

134

Regression Results

Aswath Damodaran

134

¨  Regressing changes in firm value against changes in infla]on over this period yields the following regression –

Change in Firm Value = 0.1855 + 2.9966 (Change in Infla]on Rate) (2.96) (0.90)

Conclusion: Disney’s firm value does seem to increase with infla]on, but not by much (sta]s]cal significance is low)

¨  Regressing changes in opera]ng cash flow against changes in infla]on over this period yields the following regression –

Change in Opera]ng Income = 0.1919 + 8.1867 (Change in Infla]on Rate) (3.43a) (2.76a )

Conclusion: Disney’s opera]ng income increases in periods when infla]on increases, sugges]ng that Disney does have pricing power.

135

Summarizing…

Aswath Damodaran

135

¨  Looking at the four macroeconomic regressions, we would conclude that ¤ Disney’s assets collec]vely have a dura]on of about 2.33 years

¤ Disney is increasingly affected by economic cycles ¤ Disney is hurt by a stronger dollar ¤ Disney’s opera]ng income tends to move with infla]on

¨  All of the regression coefficients have substan]al standard errors associated with them. One way to reduce the error (a la bo[om up betas) is to use sector-‐wide averages for each of the coefficients.

136

Bo[om-‐up Es]mates

Aswath Damodaran

136 These weights reflect the estimated values of the businesses

137

Recommenda]ons for Disney

Aswath Damodaran

137

¨  The debt issued should be long term and should have dura]on of about 4.3 years.

¨  A significant por]on of the debt should be floa]ng rate debt, reflec]ng Disney’s capacity to pass infla]on through to its customers and the fact that opera]ng income tends to increase as interest rates go up.

¨  Given Disney’s sensi]vity to a stronger dollar, a por]on of the debt should be in foreign currencies. The specific currency used and the magnitude of the foreign currency debt should reflect where Disney makes its revenues. Based upon 2013 numbers at least, this would indicate that about 18% of its debt should be in foreign currencies (and perhaps more, since even their US dollar income can be affected by currency movements).

138

Analyzing Disney’s Current Debt

Aswath Damodaran

138

¨  Disney has $14.3 billion in interest-‐bearing debt with a face-‐value weighted average maturity of 7.92 years. Allowing for the fact that the maturity of debt is higher than the dura]on, this would indicate that Disney’s debt may be a li[le longer than would be op]mal, but not by much.

¨  Of the debt, about 5.49% of the debt is in non-‐US dollar currencies (Indian rupees and Hong Kong dollars), but the rest is in US dollars and the company has no Euro debt. Based on our analysis, we would suggest that Disney increase its propor]on of Euro debt to about 12% and ]e the choice of currency on future debt issues to its expansion plans.

¨  Disney has no conver]ble debt and about 5.67% of its debt is floa]ng rate debt, which looks low, given the company’s pricing power. While the mix of debt in 2013 may be reflec]ve of a desire to lock in low long-‐term interest rates on debt, as rates rise, the company should consider expanding its use of foreign currency debt.

139

Adjus]ng Debt at Disney

Aswath Damodaran

139

¨  It can swap some of its exis]ng fixed rate, dollar debt for floa]ng rate, foreign currency debt. Given Disney’s standing in financial markets and its large market capitaliza]on, this should not be difficult to do.

¨  If Disney is planning new debt issues, either to get to a higher debt ra]o or to fund new investments, it can use primarily floa]ng rate, foreign currency debt to fund these new investments. Although it may be mismatching the funding on these investments, its debt matching will become be[er at the company level.

140

Debt Design for Bookscape & Vale

Aswath Damodaran

140

¨  Bookscape: Given Bookscape’s dependence on revenues at its New York bookstore, we would design the debt to be Recommenda]on: Long-‐term, dollar denominated, fixed rate debt Actual: Long term opera]ng lease on the store

¨  Vale: Vale’s mines are spread around the world, and it generates a large por]on of its revenues in China (37%). Its mines typically have very long lives and require large up-‐front investments, and the costs are usually in the local currencies but its revenues are in US dollars. ¤  Recommenda]on: Long term, dollar-‐denominated debt (with hedging of local

currency risk exposure) and if possible, ]ed to commodity prices. ¤  Actual: The exis]ng debt at Vale is primarily US dollar debt (65.48%), with an

average maturity of 14.70 years. All of the debt, as far as we can assess, is fixed rate and there is no commodity-‐linked debt.

141

And for Tata Motors and Baidu

¨  Tata Motors: As an manufacturing firm, with big chunks of its of its revenues coming from India and China (about 24% apiece) and the rest spread across developed markets. ¤  Recommenda]on: Medium to long term, fixed rate debt in a mix of

currencies reflec]ng opera]ons. ¤  Actual: The exis]ng debt at Tata Motors is a mix of Indian rupee debt

(about 71%) and Euro debt (about 29%), with an average maturity of 5.33 years and it is almost en]rely fixed rate debt.

¨  Baidu: Baidu has rela]vely li[le debt at the moment, reflec]ng its status as a young, technology company. ¤  Recommenda]on: Conver]ble, Chinese Yuan debt. ¤  Actual: About 82% of Baidu’s debt is in US dollars and Euros currently,

with an average maturity of 5.80 years. A small por]on is floa]ng rate debt, but very li[le of the debt is conver]ble.

Aswath Damodaran

141

RETURNING CASH TO THE OWNERS: DIVIDEND POLICY “Companies don’t have cash. They hold cash for their stockholders.”

Aswath Damodaran 142

143

First Principles

Aswath Damodaran

143



rate













assets.


return depends upon

current & potential








144

Steps to the Dividend Decision…

Aswath Damodaran

144

Cashflow from Operations

Cashflows to Debt(Principal repaid, Interest Expenses)

Cashflows from Operations to Equity Investors

Reinvestment back into the business

Cash available for return to stockholders

Cash held back by the company

Cash Paid out

Stock Buybacks

Dividends

How much did you borrow?

How good are your investment choices?

What is a reasonable cash balance?

What do your stockholders prefer?

145

I. Dividends are s]cky

Aswath Damodaran

145

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

Dividend Changes at US companies

Increase

Decrease

No change

146

The last quarter of 2008 put s]ckiness to the test.. Number of S&P 500 companies that…

Aswath Damodaran

146

Quarter Dividend Increase Dividend initiated Dividend decrease Dividend suspensions Q1 2007 102 1 1 1 Q2 2007 63 1 1 5 Q3 2007 59 2 2 0 Q4 2007 63 7 4 2 Q1 2008 93 3 7 4 Q2 2008 65 0 9 0 Q3 2008 45 2 6 8 Q4 2008 32 0 17 10

147

II. Dividends tend to follow earnings

Aswath Damodaran

147

0.00

20.00

40.00

60.00

80.00

100.00

120.00

Year 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

S&P 500: Dividends and Earnings -‐ 1960 to 2013

Earnings

Dividends

III. Are affected by tax laws…

In 2003 In the last quarter of 2012 ¨  As the possibility of tax

rates rever]ng back to pre-‐2003 levels rose, 233 companies paid out $31 billion in dividends.

¨  Of these companies, 101 had insider holdings in excess of 20% of the outstanding stock.

149

IV. More and more firms are buying back stock, rather than pay dividends...

Aswath Damodaran

149

$-

$100,000.00

$200,000.00

$300,000.00

$400,000.00

$500,000.00

$600,000.00

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

$ D

ivid

ends

& B

uyba

cks

Year

Stock Buybacks and Dividends: Aggregate for US Firms - 1989-2013

Stock Buybacks Dividends

150

V. And there are differences across countries…

Aswath Damodaran

150

151

Measures of Dividend Policy

Aswath Damodaran

151

¨  Dividend Payout = Dividends/ Net Income ¤ Measures the percentage of earnings that the company pays in dividends

¤  If the net income is nega]ve, the payout ra]o cannot be computed.

¨  Dividend Yield = Dividends per share/ Stock price ¤ Measures the return that an investor can make from dividends alone

¤  Becomes part of the expected return on the investment.

152

Dividend Payout Ra]os

Aswath Damodaran

152

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

0-‐10% 10-‐20% 20-‐30% 30-‐40% 40-‐50% 50-‐60% 60-‐70% 70-‐80% 70-‐90% 90-‐100% >100%

Dividend Payout Ra6os in 2014

Global

US

153

Dividend Yields: January 2013

Aswath Damodaran

153

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

Dividend Yields in 2014

Global

US


155

Dividend Yields and Payout Ra]os: Growth Classes

Aswath Damodaran

155

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

50.00%

0-‐3% 3-‐5% 5-‐10% 10-‐15% 15-‐20% 20-‐25% >25%

Dividend Yields and Payout Ra'os: By Growth Class

Dividend Payout ra]o

Dividend Yield

156

Dividend Policy: Disney, Vale, Tata Motors, Baidu and Deutsche Bank

Aswath Damodaran

156

Disney Vale Tata Motors Baidu Deutsche Bank Dividend Yield - Last 12 months 1.09% 6.56% 1.31% 0.00% 1.96% Dividend Payout ratio - Last 12 months 21.58% 113.45% 16.09% 0.00% 362.63% Dividend Yield - 2008-2012 1.17% 4.01% 1.82% 0.00% 3.14% Dividend Payout - 2008-2012 17.11% 37.69% 15.53% 0.00% 37.39%

157

Three Schools Of Thought On Dividends

1.  If there are no tax disadvantages associated with dividends & companies can issue stock, at no issuance cost, to raise equity, whenever needed

Dividends do not ma/er, and dividend policy does not affect value.

2.  If dividends create a tax disadvantage for investors (rela]ve to capital gains)

Dividends are bad, and increasing dividends will reduce value 3. If dividends create a tax advantage for investors (rela]ve to capital gains) and/or stockholders like dividends

Dividends are good, and increasing dividends will increase value

Aswath Damodaran

158

The balanced viewpoint

Aswath Damodaran

158

¨  If a company has excess cash, and few good investment opportuni]es (NPV>0), returning money to stockholders (dividends or stock repurchases) is good.

¨  If a company does not have excess cash, and/or has several good investment opportuni]es (NPV>0), returning money to stockholders (dividends or stock repurchases) is bad.

159

The Dividends don’t ma[er school The Miller Modigliani Hypothesis

Aswath Damodaran

159

¨  The Miller-‐Modigliani Hypothesis: Dividends do not affect value ¨  Basis:

¤  If a firm's investment policies (and hence cash flows) don't change, the value of the firm cannot change as it changes dividends.

¤  If a firm pays more in dividends, it will have to issue new equity to fund the same projects. By doing so, it will reduce expected price apprecia]on on the stock but it will be offset by a higher dividend yield.

¤  If we ignore personal taxes, investors have to be indifferent to receiving either dividends or capital gains.

¨  Underlying Assump]ons: (a) There are no tax differences to investors between dividends and capital gains. (b) If companies pay too much in cash, they can issue new stock, with no flota]on costs or signaling consequences, to replace this cash. (c) If companies pay too li[le in dividends, they do not use the excess cash for bad projects or acquisi]ons.

160

II. The Dividends are “bad” school: And the evidence to back them up…

Aswath Damodaran

160

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

90.00%

100.00%

1916 1918 1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 1942 1944 1946 1948 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2011 2013

Tax rates on dividends and capital gains-‐ US

Dividend tax rate Capital gains tax rate

161

What do investors in your stock think about dividends? Clues on the ex-‐dividend day!

Aswath Damodaran

161

¨  Assume that you are the owner of a stock that is approaching an ex-‐dividend day and you know that dollar dividend with certainty. In addi]on, assume that you have owned the stock for several years.

P = Price at which you bought the stock a “while” back Pb= Price before the stock goes ex-‐dividend Pa=Price aYer the stock goes ex-‐dividend D = Dividends declared on stock to, tcg = Taxes paid on ordinary income and capital gains respec]vely

Ex-dividend day

Dividend = $ D

Initial buy At $P

Pb Pa

162

Cashflows from Selling around Ex-‐Dividend Day

Aswath Damodaran

162

¨  The cash flows from selling before ex-‐dividend day are: Pb -‐ (Pb -‐ P) tcg

¨  The cash flows from selling aYer ex-‐dividend day are: Pa -‐ (Pa -‐ P) tcg + D(1-‐to)

¨  Since the average investor should be indifferent between selling before the ex-‐dividend day and selling aYer the ex-‐dividend day -‐ Pb -‐ (Pb -‐ P) tcg = Pa -‐ (Pa -‐ P) tcg + D(1-‐to)

¨  Some basic algebra leads us to the following:

€

Pb −PaD

=1− to1− tcg

163

Intui]ve Implica]ons

Aswath Damodaran

163

¨  The rela]onship between the price change on the ex-‐dividend day and the dollar dividend will be determined by the difference between the tax rate on dividends and the tax rate on capital gains for the typical investor in the stock.

Tax Rates Ex-dividend day behavior

If dividends and capital gains are taxed equally

Price change = Dividend

If dividends are taxed at a higher rate than capital gains

Price change < Dividend

If dividends are taxed at a lower rate than capital gains

Price change > Dividend

164

The empirical evidence…

Aswath Damodaran

164

•  Ordinary tax rate = 70% •  Capital gains rate = 28% •  Price chg/ Dividend = 0.78

1966-‐1969


1981-‐1985


1986-‐1990

165

Dividend Arbitrage

Aswath Damodaran

165

¨  Assume that you are a tax exempt investor, and that you know that the price drop on the ex-‐dividend day is only 90% of the dividend. How would you exploit this differen]al? a.  Invest in the stock for the long term b.  Sell short the day before the ex-‐dividend day, buy on the

ex-‐dividend day c.  Buy just before the ex-‐dividend day, and sell aYer. d.  ______________________________________________

166

Example of dividend capture strategy with tax factors

Aswath Damodaran

166

¨  XYZ company is selling for $50 at close of trading May 3. On May 4, XYZ goes ex-‐dividend; the dividend amount is $1. The price drop (from past examina]on of the data) is only 90% of the dividend amount.

¨  The transac]ons needed by a tax-‐exempt U.S. pension fund for the arbitrage are as follows: ¤  1. Buy 1 million shares of XYZ stock cum-‐dividend at $50/share. ¤  2. Wait ]ll stock goes ex-‐dividend; Sell stock for $49.10/share (50 -‐ 1* 0.90)

¤  3. Collect dividend on stock. ¨  Net profit = -‐ 50 million + 49.10 million + 1 million = $0.10 million

167

Two bad reasons for paying dividends 1. The bird in the hand fallacy

Aswath Damodaran

167

¨  Argument: Dividends now are more certain than capital gains later. Hence dividends are more valuable than capital gains. Stocks that pay dividends will therefore be more highly valued than stocks that do not.

¨  Counter: The appropriate comparison should be between dividends today and price apprecia]on today. The stock price drops on the ex-‐dividend day.

168

2. We have excess cash this year…

Aswath Damodaran

168

¨  Argument: The firm has excess cash on its hands this year, no investment projects this year and wants to give the money back to stockholders.

¨  Counter: So why not just repurchase stock? If this is a one-‐]me phenomenon, the firm has to consider future financing needs. The cost of raising new financing in future years, especially by issuing new equity, can be staggering.

169

The Cost of Raising Capital

Aswath Damodaran

169

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

Under $1 mil $1.0-1.9 mil $2.0-4.9 mil $5.0-$9.9 mil $10-19.9 mil $20-49.9 mil $50 mil and over

Cost

as %

of f

unds

raise

d

Size of Issue

Figure 10.12: Issuance Costs for Stocks and Bonds

Cost of Issuing bonds Cost of Issuing Common Stock

170

Three “good” reasons for paying dividends…

Aswath Damodaran

170

¨  Clientele Effect: The investors in your company like dividends.

¨  The Signalling Story: Dividends can be signals to the market that you believe that you have good cash flow prospects in the future.

¨  The Wealth Appropria]on Story: Dividends are one way of transferring wealth from lenders to equity investors (this is good for equity investors but bad for lenders)

171

1. The Clientele Effect The “strange case” of Ci]zen’s U]lity

Aswath Damodaran

171

Class A shares pay cash dividend Class B shares offer the same amount as a stock dividend & can be converted to class A shares

172

Evidence from Canadian firms

Aswath Damodaran

172

Company Premium for cash dividend shares Consolidated Bathurst + 19.30% Donfasco + 13.30% Dome Petroleum + 0.30% Imperial Oil +12.10% Newfoundland Light & Power + 1.80% Royal Trustco + 17.30% Stelco + 2.70% TransAlta +1.10% Average across companies + 7.54%

173

A clientele based explana]on

Aswath Damodaran

173

¨  Basis: Investors may form clienteles based upon their tax brackets. Investors in high tax brackets may invest in stocks which do not pay dividends and those in low tax brackets may invest in dividend paying stocks.

¨  Evidence: A study of 914 investors' por�olios was carried out to see if their por�olio posi]ons were affected by their tax brackets. The study found that ¤  (a) Older investors were more likely to hold high dividend stocks and

¤  (b) Poorer investors tended to hold high dividend stocks

Results from Regression: Clientele Effect

D i v i d e n d Y i e l d t = a + b β t + c A g e t + d I n c o m e t + e D i f f e r e n t i a l T a x R a t e t + ε t

V a r i a b l e C o e f f i c i e n t I m p l i e s

C o n s t a n t 4 . 2 2 %

B e t a C o e f f i c i e n t -‐ 2 . 1 4 5 H i g h e r b e t a s t o c k s p a y l o w e r d i v i d e n d s .

A g e / 1 0 0 3 . 1 3 1 F i r m s w i t h o l d e r i n v e s t o r s p a y h i g h e r

d i v i d e n d s .

I n c o m e / 1 0 0 0 -‐ 3 . 7 2 6 F i r m s w i t h w e a l t h i e r i n v e s t o r s p a y l o w e r

d i v i d e n d s .

D i f f e r e n t i a l T a x R a t e -‐ 2 . 8 4 9 I f o r d i n a r y i n c o m e i s t a x e d a t a h i g h e r r a t e

t h a n c a p i t a l g a i n s , t h e f i r m p a y s l e s s

d i v i d e n d s .

175

Dividend Policy and Clientele

Aswath Damodaran

175

¨  Assume that you run a phone company, and that you have historically paid large dividends. You are now planning to enter the telecommunica]ons and media markets. Which of the following paths are you most likely to follow?

a.  Courageously announce to your stockholders that you plan to cut dividends and invest in the new markets.

b.  Con]nue to pay the dividends that you used to, and defer investment in the new markets.

c.  Con]nue to pay the dividends that you used to, make the investments in the new markets, and issue new stock to cover the shor�all

d.  Other

176

2. Dividends send a signal” Increases in dividends are good news..

Aswath Damodaran

176

177

But higher or new dividends may signal bad news (not good)

Aswath Damodaran

177

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

-‐4 -‐3 -‐2 -‐1 1 2 3 4

Annu

al Earnings G

rowth Rate

Year rela6ve to dividend ini6a6on (Before and a[er)

Dividend Ini6a6ons and Earnings Growth

Both dividend increases and decreases are becoming less informa]ve…

-‐6.00%

-‐5.00%

-‐4.00%

-‐3.00%

-‐2.00%

-‐1.00%

0.00%

1.00%

1962-‐1974 1975-‐1987 1988-‐2000

Market Reaction to Dividend Changes over time: US companies

Dividend Increases

Dividend Decreases

3. Dividend increases may be good for stocks… but bad for bonds..

-2!

-1.5!

-1!

-0.5!

0!

0.5!

t:-!15!

-12! -9! -6! -3! 0! 3! 6! 9! 12! 15!

CAR (Div Up)!

CAR (Div down)!

EXCESS RETURNS ON STOCKS AND BONDS AROUND DIVIDEND CHANGES!

Day (0: Announcement date)!

CAR!

Bond price drops

Stock price rises

180

What managers believe about dividends…

Aswath Damodaran

180

ASSESSING DIVIDEND POLICY: OR HOW MUCH CASH IS TOO MUCH?

It is my cash and I want it now…


182

The Big Picture…

Aswath Damodaran

182



rate













assets.


return depends upon

current & potential








183

Assessing Dividend Policy

Aswath Damodaran

183

¨  Approach 1: The Cash/Trust Nexus ¤  Assess how much cash a firm has available to pay in dividends, rela]ve what it returns to stockholders. Evaluate whether you can trust the managers of the company as custodians of your cash.

¨  Approach 2: Peer Group Analysis ¤  Pick a dividend policy for your company that makes it comparable to other firms in its peer group.

184

I. The Cash/Trust Assessment

Aswath Damodaran

184

Step 1: How much did the the company actually pay out during the period in ques]on? Step 2: How much could the company have paid out during the period under ques]on? Step 3: How much do I trust the management of this company with excess cash?

¤ How well did they make investments during the period in ques]on?

¤ How well has my stock performed during the period in ques]on?

185

How much has the company returned to stockholders?

Aswath Damodaran

185

¨  As firms increasing use stock buybacks, we have to measure cash returned to stockholders as not only dividends but also buybacks.

¨  For instance, for the five companies we are analyzing the cash returned looked as follows. Disney Vale Tata Motors Baidu Deutsche Bank

Year Dividends Buybacks Dividends Buybacks Dividends Buybacks Dividends Buybacks Dividends Buybacks 2008 $648 $648 $2,993 $741 7,595₹ 0₹ ¥0 ¥0 2,274 € 0 € 2009 $653 $2,669 $2,771 $9 3,496₹ 0₹ ¥0 ¥0 309 € 0 € 2010 $756 $4,993 $3,037 $1,930 10,195₹ 0₹ ¥0 ¥0 465 € 0 € 2011 $1,076 $3,015 $9,062 $3,051 15,031₹ 0₹ ¥0 ¥0 691 € 0 € 2012 $1,324 $4,087 $6,006 $0 15,088₹ 970₹ ¥0 ¥0 689 € 0 €

2008-‐12 $4,457 $15,412 $23,869 $5,731 51,405₹ 970₹ ¥0 ¥0 ¥4,428 ¥0

186

A Measure of How Much a Company Could have Afforded to Pay out: FCFE

Aswath Damodaran

186

¨  The Free Cashflow to Equity (FCFE) is a measure of how much cash is leY in the business aYer non-‐equity claimholders (debt and preferred stock) have been paid, and aYer any reinvestment needed to sustain the firm’s assets and future growth.

Net Income + Deprecia]on & Amor]za]on = Cash flows from Opera]ons to Equity Investors -‐ Preferred Dividends -‐ Capital Expenditures -‐ Working Capital Needs = FCFE before net debt cash flow (Owner’s Earnings) + New Debt Issues -‐ Debt Repayments = FCFE aYer net debt cash flow

187

Es]ma]ng FCFE when Leverage is Stable

Aswath Damodaran

187

¨  The cash flow from debt (debt issue, ne[ed out against repayment) can be a vola]le number, crea]ng big increases or decreases in FCFE, depending upon the period examined.

¨  To provide a more balanced measure, you can es]mate a FCFE, assuming a stable debt ra]o had been used to fund reinvestment over the period. Net Income -‐ (1-‐ Debt Ra]o) (Capital Expenditures -‐ Deprecia]on) -‐ (1-‐ Debt Ra]o) Working Capital Needs = Free Cash flow to Equity Debt Ra]o = Debt/Capital Ra]o (either an actual or a target)

188

Disney’s FCFE and Cash Returned: 2008 – 2012

Aswath Damodaran

2012 2011 2010 2009 2008 Aggregate

Net Income $6,136 $5,682 $4,807 $3,963 $3,307 $23,895

- (Cap. Exp - Depr) $604 $1,797 $1,718 $397 $122 $4,638

- ∂ Working Capital ($133) $940 $950 $308 ($109) $1,956

Free CF to Equity (pre-debt) $5,665 $2,945 $2,139 $3,258 $3,294 $17,301

+ Net Debt Issued $1,881 $4,246 $2,743 $1,190 ($235) $9,825

= Free CF to Equity (actual debt) $7,546 $7,191 $4,882 $4,448 $3,059 $27,126

Free CF to Equity (target debt ratio) $5,720 $3,262 $2,448 $3,340 $3,296 $18,065

Dividends $1,324 $1,076 $756 $653 $648 $4,457

Dividends + Buybacks $5,411 $4,091 $5,749 $3,322 $1,296 $19,869

Disney returned about $1.5 billion more than the $18.1 billion it had available as FCFE with a normalized debt ratio of 11.58% (its current debt ratio).

189

How companies get big cash balances: MicrosoY in 1996…

Aswath Damodaran

189

¨  Consider the following inputs for MicrosoY in 1996. ¤  Net Income = $2,176 Million ¤  Capital Expenditures = $494 Million ¤  Deprecia]on = $ 480 Million ¤  Change in Non-‐Cash Working Capital = $ 35 Million ¤  Debt = None

FCFE = Net Income -‐ (Cap ex -‐ Depr) – Change in non-‐cash WC – Debt CF = $ 2,176 -‐ (494 -‐ 480) -‐ $ 35 -‐ 0 = $ 2,127 Million

¨  By this es]ma]on, MicrosoY could have paid $ 2,127 Million in dividends/stock buybacks in 1996. They paid no dividends and bought back no stock. Where will the $2,127 million show up in MicrosoY’s balance sheet?

190

FCFE for a Bank?

¨  We redefine reinvestment as investment in regulatory capital. FCFEBank= Net Income – Increase in Regulatory Capital (Book Equity)

¨  Consider a bank with $ 10 billion in loans outstanding and book equity of $ 750 million. If it maintains its capital ra]o of 7.5%, intends to grow its loan base by 10% (to $11 and expects to generate $ 150 million in net income:

FCFE = $150 million – (11,000-‐10,000)* (.075) = $75 million

Aswath Damodaran

Deutsche Bank: FCFE estimates (November 2013) Current 1 2 3 4 5 Risk Adjusted Assets (grows 3% each year) 439,851 € 453,047 € 466,638 € 480,637 € 495,056 € 509,908 € Tier 1 as % of Risk Adj assets 15.13% 15.71% 16.28% 16.85% 17.43% 18.00% Tier 1 Capital 66,561 € 71,156 € 75,967 € 81,002 € 86,271 € 91,783 € Change in regulatory capital 4,595 € 4,811 € 5,035 € 5,269 € 5,512 € Book Equity 76,829 € 81,424 € 86,235 € 91,270 € 96,539 € 102,051 € ROE (increases to 8%) -1.08% 0.74% 2.55% 4.37% 6.18% 8.00% Net Income -716 € 602 € 2,203 € 3,988 € 5,971 € 8,164 € - Investment in Regulatory Capital 4,595 € 4,811 € 5,035 € 5,269 € 5,512 € FCFE -3,993 € -2,608 € -1,047 € 702 € 2,652 €

191

Dividends versus FCFE: Across the globe

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

Australia, NZ and Canada

Developed Europe

Emerging Markets

Japan United States Global

Figure 11.2: Dividends versus FCFE in 2014

FCFE<0, No dividends

FCFE<0, Dividends

FCFE>0, FCFE<Dividends

FCFE>0, No dividends

FCFE>0,FCFE>Dividends

Aswath Damodaran

192

Cash Buildup and Investor Blowback: Chrysler in 1994

Aswath Damodaran

192

Chrysler: FCFE, Dividends and Cash Balance

($500)

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

Yea r

Cash

Fl

ow

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000

Cash

Ba

lanc

e

= Free CF to Equity = Cash to Stockholders Cumulated Cash

193

6 Applica]on Test: Es]ma]ng your firm’s FCFE

Aswath Damodaran

193

¨  In General, If cash flow statement used Net Income Net Income + Deprecia]on & Amor]za]on + Deprecia]on & Amor]za]on -‐ Capital Expenditures + Capital Expenditures -‐ Change in Non-‐Cash Working Capital + Changes in Non-‐cash WC -‐ Preferred Dividend + Preferred Dividend -‐ Principal Repaid + Increase in LT Borrowing + New Debt Issued + Decrease in LT Borrowing

+ Change in ST Borrowing = FCFE = FCFE

¨  Compare to Dividends (Common) Common Dividend + Stock Buybacks Stock Buybacks

194

A Prac]cal Framework for Analyzing Dividend Policy

Aswath Damodaran

194

How much did the firm pay out? How much could it have afforded to pay out?"What it could have paid out! What it actually paid out!Net Income" Dividends"- (Cap Ex - Depr’n) (1-DR)" + Equity Repurchase"- Chg Working Capital (1-DR)"= FCFE"

Firm pays out too little"FCFE > Dividends" Firm pays out too much"

FCFE < Dividends"

Do you trust managers in the company with!your cash?!Look at past project choice:"Compare" ROE to Cost of Equity"

ROC to WACC"

What investment opportunities does the !firm have?!Look at past project choice:"Compare" ROE to Cost of Equity"

ROC to WACC"

Firm has history of "good project choice "and good projects in "the future"

Firm has history"of poor project "choice"

Firm has good "projects"

Firm has poor "projects"

Give managers the "flexibility to keep "cash and set "dividends"

Force managers to "justify holding cash "or return cash to "stockholders"

Firm should "cut dividends "and reinvest "more "

Firm should deal "with its investment "problem first and "then cut dividends"

195

A Dividend Matrix

Aswath Damodaran

195

Quality of projects taken: Excess ReturnsPoor projects Good projects

Cash Surplus + Good ProjectsMaximum flexibility in setting dividend policy

Cash Surplus + Poor ProjectsSignificant pressure to pay out more to stockholders as dividends or stock buybacks

Cash Deficit + Good ProjectsReduce cash payout, if any, to stockholders

Cash Deficit + Poor ProjectsReduce or eliminate cash return but real problem is in investment policy.

Cas

h R

etur

ned,

rela

tive

to F

ree

Cas

h flo

w to

Equ

ity

Cas

h R

etur

n <

FCFE

Cas

h re

turn

> F

CFE

196

More on MicrosoY

Aswath Damodaran

196

¨  MicrosoY had accumulated a cash balance of $ 43 billion by 2002by paying out no dividends while genera]ng huge FCFE. At the end of 2003, there was no evidence that MicrosoY was being penalized for holding such a large cash balance or that stockholders were becoming res]ve about the cash balance. There was no hue and cry demanding more dividends or stock buybacks. Why?

¨  In 2004, MicrosoY announced a huge special dividend of $ 33 billion and made clear that it would try to return more cash to stockholders in the future. What do you think changed?

197

Case 1: Disney in 2003

Aswath Damodaran

197

¨  FCFE versus Dividends ¤  Between 1994 & 2003, Disney generated $969 million in FCFE each

year. ¤  Between 1994 & 2003, Disney paid out $639 million in dividends and

stock buybacks each year. ¨  Cash Balance

¤  Disney had a cash balance in excess of $ 4 billion at the end of 2003. ¨  Performance measures

¤  Between 1994 and 2003, Disney has generated a return on equity, on it’s projects, about 2% less than the cost of equity, on average each year.

¤  Between 1994 and 2003, Disney’s stock has delivered about 3% less than the cost of equity, on average each year.

¤  The underperformance has been primarily post 1996 (aYer the Capital Ci]es acquisi]on).

198

Can you trust Disney’s management?

Aswath Damodaran

198

¨  Given Disney’s track record between 1994 and 2003, if you were a Disney stockholder, would you be comfortable with Disney’s dividend policy?

a.  Yes b.  No ¨  Does the fact that the company is run by Michael Eisner, the CEO for the last 10 years and the ini]ator of the Cap Ci]es acquisi]on have an effect on your decision.

a.  Yes b.  No

199

The Bo[om Line on Disney Dividends in 2003

Aswath Damodaran

199

¨  Disney could have afforded to pay more in dividends during the period of the analysis.

¨  It chose not to, and used the cash for acquisi]ons (Capital Ci]es/ABC) and ill fated expansion plans (Go.com).

¨  While the company may have flexibility to set its dividend policy a decade ago, its ac]ons over that decade have fri[ered away this flexibility.

¨  Bo[om line: Large cash balances would not be tolerated in this company. Expect to face relentless pressure to pay out more dividends.

200

Following up: Disney in 2009

¨  Between 2004 and 2008, Disney made significant changes: ¤  It replaced its CEO, Michael Eisner, with a new CEO, Bob Iger, who at

least on the surface seemed to be more recep]ve to stockholder concerns.

¤  Its stock price performance improved (posi]ve Jensen’s alpha) ¤  Its project choice improved (ROC moved from being well below cost of

capital to above) ¨  The firm also shiYed from cash returned < FCFE to cash

returned > FCFE and avoided making large acquisi]ons. ¨  If you were a stockholder in 2009 and Iger made a plea to

retain cash in Disney to pursue investment opportuni]es, would you be more recep]ve? a.  Yes b.  No

Aswath Damodaran

201

Final twist: Disney in 2013

¨  Disney did return to holding cash between 2008 and 2013, with dividends and buybacks amoun]ng TO $2.6 billion less than the FCFE (with a target debt ra]o) over this period.

¨  Disney con]nues to earn a return on capital well in excess of the cost of capital and its stock has doubled over the last two years.

¨  Now, assume that Bob Iger asks you for permission to withhold even more cash to cover future investment needs. Are you likely to go along?

a.  Yes b.  No

Aswath Damodaran

202

Case 2: Vale – Dividends versus FCFE

Aswath Damodaran

Aggregate Average Net Income $57,404 $5,740 Dividends $36,766 $3,677 Dividend Payout Ratio $1 $1 Stock Buybacks $6,032 $603 Dividends + Buybacks $42,798 $4,280 Cash Payout Ratio $1 Free CF to Equity (pre-debt) ($1,903) ($190) Free CF to Equity (actual debt) $1,036 $104

Free CF to Equity (target debt ratio) $19,138 $1,914

Cash payout as % of pre-debt FCFE FCFE negative Cash payout as % of actual FCFE 4131.08% Cash payout as % of target FCFE 223.63%

203

Vale: Its your call..

¨  Vale’s managers have asked you for permission to cut dividends (to more manageable levels). Are you likely to go along? a.  Yes b.  No

¨  The reasons for Vale’s dividend problem lie in it’s equity structure. Like most Brazilian companies, Vale has two classes of shares -‐ common shares with vo]ng rights and preferred shares without vo]ng rights. However, Vale has commi[ed to paying out 35% of its earnings as dividends to the preferred stockholders. If they fail to meet this threshold, the preferred shares get vo]ng rights. If you own the preferred shares, would your answer to the ques]on above change? a.  Yes b.  No

Aswath Damodaran

204

Mandated Dividend Payouts

Aswath Damodaran

204

¨  Assume now that the government decides to mandate a minimum dividend payout for all companies. Given our discussion of FCFE, what types of companies will be hurt the most by such a mandate?

a.  Large companies making huge profits b.  Small companies losing money c.  High growth companies that are losing money d.  High growth companies that are making money ¨  What if the government mandates a cap on the dividend payout ra]o (and a requirement that all companies reinvest a por]on of their profits)?

205

Case 3: BP: Summary of Dividend Policy: 1982-‐1991

Aswath Damodaran

205

Summary of calculations Average Standard Deviation Maximum Minimum

Free CF to Equity $571.10 $1,382.29 $3,764.00 ($612.50) Dividends $1,496.30 $448.77 $2,112.00 $831.00 Dividends+Repurchases $1,496.30 $448.77 $2,112.00 $831.00

Dividend Payout Ratio 84.77% Cash Paid as % of FCFE 262.00%

ROE - Required return -1.67% 11.49% 20.90% -21.59%

206

BP: Just Desserts!

Aswath Damodaran

206

207

Managing changes in dividend policy

Aswath Damodaran

207

208

Case 4: The Limited: Summary of Dividend Policy: 1983-‐1992

Aswath Damodaran

208

Summary of calculations Average Standard Deviation Maximum Minimum

Free CF to Equity ($34.20) $109.74 $96.89 ($242.17) Dividends $40.87 $32.79 $101.36 $5.97 Dividends+Repurchases $40.87 $32.79 $101.36 $5.97

Dividend Payout Ratio 18.59% Cash Paid as % of FCFE -119.52%

ROE - Required return 1.69% 19.07% 29.26% -19.84%

209

Growth Firms and Dividends

Aswath Damodaran

209

¨  High growth firms are some]mes advised to ini]ate dividends because its increases the poten]al stockholder base for the company (since there are some investors -‐ like pension funds -‐ that cannot buy stocks that do not pay dividends) and, by extension, the stock price. Do you agree with this argument?

a.  Yes b.  No ¨  Why?

210

5. Tata Motors

Negative FCFE, largely because of acquisitions.

Aswath Damodaran

Aggregate Average Net Income $421,338.00 $42,133.80 Dividends $74,214.00 $7,421.40 Dividend Payout Ratio 17.61% 15.09% Stock Buybacks $970.00 $97.00 Dividends + Buybacks $75,184.00 $7,518.40 Cash Payout Ratio 17.84% Free CF to Equity (pre-debt) ($106,871.00) ($10,687.10) Free CF to Equity (actual debt) $825,262.00 $82,526.20 Free CF to Equity (target debt ratio) $47,796.36 $4,779.64 Cash payout as % of pre-debt FCFE FCFE negative Cash payout as % of actual FCFE 9.11% Cash payout as % of target FCFE 157.30%

211

Summing up…

Aswath Damodaran

211

Cas

h Su

rplu

sC

ash

Defi

cit

Divid

ends

pai

d ou

t rel

ative

to F

CFE

Quality of projects taken: ROE versus Cost of EquityPoor projects Good projects

Cash Surplus + Good ProjectsMaximum flexibility in setting dividend policy

Cash Surplus + Poor ProjectsSignificant pressure to pay out more to stockholders as dividends or stock buybacks

Cash Deficit + Good ProjectsReduce cash payout, if any, to stockholders

Cash Deficit + Poor ProjectsCut out dividends but real problem is in investment policy.

Disney

Vale

Baidu

Deutsche Bank

Tata Mtrs

212

6 Applica]on Test: Assessing your firm’s dividend policy

Aswath Damodaran

212

¨  Compare your firm’s dividends to its FCFE, looking at the last 5 years of informa]on.

¨  Based upon your earlier analysis of your firm’s project choices, would you encourage the firm to return more cash or less cash to its owners?

¨  If you would encourage it to return more cash, what form should it take (dividends versus stock buybacks)?

213

II. The Peer Group Approach

Aswath Damodaran

¨  In the peer group approach, you compare your company to similar companies (usually in the same market and sector) to assess whether and if yes, how much to pay in dividends.

Dividend Yield Dividend Payout Company 2013 Average 2008-‐12 2013 Average 2008-‐12 Comparable Group Dividend Yield Dividend Payout Disney 1.09% 1.17% 21.58% 17.11% US Entertainment 0.96% 22.51%

Vale 6.56% 4.01% 113.45% 37.69%

Global Diversified Mining & Iron Ore (Market cap> $1 b) 3.07% 316.32%

Tata Motors 1.31% 1.82% 16.09% 15.53% Global Autos (Market

Cap> $1 b) 2.13% 27.00%

Baidu 0.00% 0.00% 0.00% 0.00% Global Online Advertising 0.09% 8.66%

Deutsche Bank 1.96% 3.14% 362.63% 37.39% European Banks 1.96% 79.32%

214

A closer look at Disney’s peer group

Aswath Damodaran

214

Company Market

Cap Dividends Dividends +

Buybacks Net

Income FCFE Dividend

Yield Dividend Payout

Cash Return/FCFE

The Walt Disney Company $134,256 $1,324 $5,411 $6,136 $1,503 0.99% 21.58% 360.01% Twenty-First Century Fox, Inc. $79,796 $415 $2,477 $7,097 $2,408 0.52% 6.78% 102.87% Time Warner Inc $63,077 $1,060 $4,939 $3,019 -$4,729 1.68% 27.08% NA Viacom, Inc. $38,974 $555 $5,219 $2,395 -$2,219 1.42% 23.17% NA The Madison Square Garden Co. $4,426 $0 $0 $142 -$119 0.00% 0.00% NA Lions Gate Entertainment Corp $4,367 $0 $0 $232 -$697 0.00% 0.00% NA Live Nation Entertainment, Inc $3,894 $0 $0 -$163 $288 0.00% NA 0.00% Cinemark Holdings Inc $3,844 $101 $101 $169 -$180 2.64% 63.04% NA MGM Holdings Inc $3,673 $0 $59 $129 $536 0.00% 0.00% 11.00% Regal Entertainment Group $3,013 $132 $132 $145 -$18 4.39% 77.31% NA DreamWorks Animation SKG Inc. $2,975 $0 $34 -$36 -$572 0.00% NA NA AMC Entertainment Holdings $2,001 $0 $0 $63 -$52 0.00% 0.00% NA World Wrestling Entertainment $1,245 $36 $36 $31 -$27 2.88% 317.70% NA SFX Entertainment Inc. $1,047 $0 $0 -$16 -$137 0.00% NA NA Carmike Cinemas Inc. $642 $0 $0 $96 $64 0.00% 0.00% 0.27% Rentrak Corporation $454 $0 $0 -$23 -$13 0.00% NA NA Reading International, Inc. $177 $0 $0 -$1 $15 0.00% 0.00% 0.00% Average $20,462 $213 $1,083 $1,142 -$232 0.85% 41.28% 79.02% Median $3,673 $0 $34 $129 -$27 0.00% 6.78% 5.63%

215

Going beyond averages… Looking at the market

Aswath Damodaran

215

¨  Regressing dividend yield and payout against expected growth across all US companies in January 2014 yields:

PYT = Dividend Payout Ra]o = Dividends/Net Income YLD = Dividend Yield = Dividends/Current Price BETA = Beta (Regression or Bo[om up) for company EGR = Expected growth rate in earnings over next 5 years (analyst es]mates) DCAP = Total Debt / (Total Debt + Market Value of equity)

216

Using the market regression on Disney

Aswath Damodaran

216

¨  To illustrate the applicability of the market regression in analyzing the dividend policy of Disney, we es]mate the values of the independent variables in the regressions for the firm. ¤  Beta for Disney (bo[om up) = 1.00 ¤  Disney’s expected growth in earnings per share = 14.73% (analyst

es]mate) ¤  Disney’s market debt to capital ra]o = 11.58%

¨  Subs]tu]ng into the regression equa]ons for the dividend payout ra]o and dividend yield, we es]mate a predicted payout ra]o: ¤  Predicted Payout = .649 – 0.296 (1.00)-‐.800 (.1473) + .300 (.1158) = .2695 ¤  Predicted Yield = 0.0324 – .0154 (1.00)-‐.038 (.1473) + .023 (.1158) = .0140

¤  Based on this analysis, Disney with its dividend yield of 1.09% and a payout ra]o of approximately 21.58% is paying too li[le in dividends. This analysis, however, fails to factor in the huge stock buybacks made by Disney over the last few years.

VALUATION Cynic: A person who knows the price of everything but the value of nothing.. Oscar Wilde


218

First Principles

Aswath Damodaran

218



rate













assets.


return depends upon

current & potential








219

Three approaches to valua]on

Aswath Damodaran

219

¨  Intrinsic valua]on: The value of an asset is a func]on of its fundamentals – cash flows, growth and risk. In general, discounted cash flow models are used to es]mate intrinsic value.

¨  Rela]ve valua]on: The value of an asset is es]mated based upon what investors are paying for similar assets. In general, this takes the form of value or price mul]ples and comparing firms within the same business.

¨  Con]ngent claim valua]on: When the cash flows on an asset are con]ngent on an external event, the value can be es]mated using op]on pricing models.

220

One tool for es]ma]ng intrinsic value: Discounted Cash Flow Valua]on

Aswath Damodaran

220

Cash flows from existing assetsThe base earnings will reflect the

earnings power of the existing assets of the firm, net of taxes and

any reinvestment needed to sustain the base earnings.

Value of growthThe future cash flows will reflect expectations of how quickly earnings will grow in the future (as a positive) and how much the company will have to reinvest to generate that growth (as a negative). The net effect will determine the value of growth.

Expected Cash Flow in year t = E(CF) = Expected Earnings in year t - Reinvestment needed for growth

Risk in the Cash flowsThe risk in the investment is captured in the discount rate as a beta in the cost of equity and the default spread in the cost

of debt.

Steady stateThe value of growth comes from the capacity to generate excess

returns. The length of your growth period comes from the strength & sustainability of your competitive

advantages.

221

Equity Valua]on

Aswath Damodaran

221

¨  The value of equity is obtained by discoun]ng expected cashflows to equity, i.e., the residual cashflows aYer mee]ng all expenses, tax obliga]ons and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm.

where, CF to Equity t = Expected Cashflow to Equity in period t ke = Cost of Equity

¨  The dividend discount model is a specialized case of equity valua]on, and the value of a stock is the present value of expected future dividends.

Value of Equity= CF to Equityt

(1+ke )tt=1

t=n

∑

222

Firm Valua]on

Aswath Damodaran

222

¨  The value of the firm is obtained by discoun]ng expected cashflows to the firm, i.e., the residual cashflows aYer mee]ng all opera]ng expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value propor]ons.

where, CF to Firm t = Expected Cashflow to Firm in period t WACC = Weighted Average Cost of Capital

Value of Firm= CF to Firmt

(1+WACC)tt=1

t=n

∑

223

Choosing a Cash Flow to Discount

Aswath Damodaran

223

¨  When you cannot es]mate the free cash flows to equity or the firm, the only cash flow that you can discount is dividends. For financial service firms, it is difficult to es]mate free cash flows. For Deutsche Bank, we will be discoun]ng dividends.

¨  If a firm’s debt ra]o is not expected to change over ]me, the free cash flows to equity can be discounted to yield the value of equity. For Tata Motors, we will discount free cash flows to equity.

¨  If a firm’s debt ra]o might change over ]me, free cash flows to equity become cumbersome to es]mate. Here, we would discount free cash flows to the firm. For Vale and Disney, we will discount the free cash flow to the firm.

224

The Ingredients that determine value.

Aswath Damodaran

224

225

I. Es]ma]ng Cash Flows

Aswath Damodaran

225

226

Dividends and Modified Dividends for Deutsche Bank

Aswath Damodaran

226

¨  In 2007, Deutsche Bank paid out dividends of 2,146 million Euros on net income of 6,510 million Euros. In early 2008, we valued Deutsche Bank using the dividends it paid in 2007. In my 2008 valua]on I am assuming the dividends are not only reasonable but sustainable.

¨  In November 2013, Deutsche Bank’s dividend policy was in flux. Not only did it report losses but it was on a pathway to increase its regulatory capital ra]o. Rather than focus on the dividends (which were small), we es]mated the poten]al dividends (by es]ma]ng the free cash flows to equity aYer investments in regulatory capital)

Current 2014 2015 2016 2017 2018 Steady state Asset Base 439,851 € 453,047 € 466,638 € 480,637 € 495,056 € 509,908 € 517,556 € Capital ratio 15.13% 15.71% 16.28% 16.85% 17.43% 18.00% 18.00% Tier 1 Capital 66,561 € 71,156 € 75,967 € 81,002 € 86,271 € 91,783 € 93,160 € Change in regulatory capital 4,595 € 4,811 € 5,035 € 5,269 € 5,512 € 1,377 € Book Equity 76,829 € 81,424 € 86,235 € 91,270 € 96,539 € 102,051 € 103,605 € ROE -1.08% 0.74% 2.55% 4.37% 6.18% 8.00% 8.00% Net Income -716 € 602 € 2,203 € 3,988 € 5,971 € 8,164 € 8,287 € - Investment in Regulatory Capital 4,595 € 4,811 € 5,035 € 5,269 € 5,512 € 1,554 € FCFE -3,993 € -2,608 € -1,047 € 702 € 2,652 € 6,733 €

227

Es]ma]ng FCFE (past) : Tata Motors

Aswath Damodaran

227

Year Net Income Cap Ex Depreciatio

n Change in

WC Change in

Debt Equity

Reinvestment

Equity Reinvestment

Rate 2008-‐09 -‐25,053₹ 99,708₹ 25,072₹ 13,441₹ 25,789₹ 62,288₹ -‐248.63% 2009-‐10 29,151₹ 84,754₹ 39,602₹ -‐26,009₹ 5,605₹ 13,538₹ 46.44% 2010-‐11 92,736₹ 81,240₹ 46,510₹ 50,484₹ 24,951₹ 60,263₹ 64.98% 2011-‐12 135,165₹ 138,756₹ 56,209₹ 22,801₹ 30,846₹ 74,502₹ 55.12% 2012-‐13 98,926₹ 187,570₹ 75,648₹ 680₹ 32,970₹ 79,632₹ 80.50% Aggregate 330,925₹ 592,028₹ 243,041₹ 61,397₹ 120,160₹ 290,224₹ 87.70%

228

Es]ma]ng FCFF: Disney

¨  In the fiscal year ended September 2013, Disney reported the following: ¤  Opera]ng income (adjusted for leases) = $10,032 million ¤  Effec]ve tax rate = 31.02% ¤  Capital Expenditures (including acquisi]ons) = $5,239 million ¤  Deprecia]on & Amor]za]on = $2.192 million ¤  Change in non-‐cash working capital = $103 million

¨  The free cash flow to the firm can be computed as follows: AYer-‐tax Opera]ng Income = 10,032 (1 -‐.3102) = $6,920 -‐ Net Cap Expenditures = $5,239 -‐ $2,192 = $3,629 -‐  Change in Working Capital = =$103 = Free Cashflow to Firm (FCFF) = = $3,188

¨  The reinvestment and reinvestment rate are as follows: ¤  Reinvestment = $3,629 + $103 = $3,732 million ¤  Reinvestment Rate = $3,732/ $6,920 = 53.93%

Aswath Damodaran

229

II. Discount Rates

Aswath Damodaran

229

¨  Cri]cal ingredient in discounted cashflow valua]on. Errors in es]ma]ng the discount rate or mismatching cashflows and discount rates can lead to serious errors in valua]on.

¨  At an intui]ve level, the discount rate used should be consistent with both the riskiness and the type of cashflow being discounted.

¨  The cost of equity is the rate at which we discount cash flows to equity (dividends or free cash flows to equity). The cost of capital is the rate at which we discount free cash flows to the firm.

230

Cost of Equity: Deutsche Bank 2008 versus 2013

Aswath Damodaran

230

¨  In early 2008, we es]mated a beta of 1.162 for Deutsche Bank, which used in conjunc]on with the Euro risk-‐free rate of 4% (in January 2008) and an equity risk premium of 4.50%, yielded a cost of equity of 9.23%. Cost of Equity Jan 2008 = Riskfree Rate Jan 2008 + Beta* Mature Market Risk Premium

= 4.00% + 1.162 (4.5%) = 9.23% ¨  In November 2013, the Euro riskfree rate had dropped to 1.75% and the Deutsche’s equity risk premium had risen to 6.12%: Cost of equity Nov ’13 = Riskfree Rate Nov ‘13 + Beta (ERP)

= 1.75% + 1.1516 (6.12%) = 8.80%

231

Cost of Equity: Tata Motors

Aswath Damodaran

231

¨  We will be valuing Tata Motors in rupee terms. That is a choice. Any company can be valued in any currency.

¨  Earlier, we es]mated a levered beta for equity of 1.1007 for Tata Motor’s opera]ng assets . Since we will be discoun]ng FCFE with the income from cash included in the cash, we recomputed a beta for Tata Motors as a company (with cash): Levered BetaCompany= 1.1007 (1428/1630)+ 0 (202/1630) = 0.964

¨  With a nominal rupee risk-‐free rate of 6.57 percent and an equity risk premium of 7.19% for Tata Motors, we arrive at a cost of equity of 13.50%.

Cost of Equity = 6.57% + 0.964 (7.19%) = 13.50%

232

Current Cost of Capital: Disney

¨  The beta for Disney’s stock in November 2013 was 1.0013. The T. bond rate at that ]me was 2.75%. Using an es]mated equity risk premium of 5.76%, we es]mated the cost of equity for Disney to be 8.52%:

Cost of Equity = 2.75% + 1.0013(5.76%) = 8.52% ¨  Disney’s bond ra]ng in May 2009 was A, and based on this ra]ng,

the es]mated pretax cost of debt for Disney is 3.75%. Using a marginal tax rate of 36.1, the aYer-‐tax cost of debt for Disney is 2.40%.

AYer-‐Tax Cost of Debt = 3.75% (1 – 0.361) = 2.40% ¨  The cost of capital was calculated using these costs and the

weights based on market values of equity (121,878) and debt (15.961):

Cost of capital =

Aswath Damodaran

8.52% 121,878(15,961+121,878)

+ 2.40% 15,961(15,961+121,878)

= 7.81%

233

But costs of equity and capital can and should change over ]me…

Aswath Damodaran

Year Beta Cost of Equity

AYer-‐tax Cost of Debt Debt Ra]o Cost of capital

1 1.0013 8.52% 2.40% 11.50% 7.81% 2 1.0013 8.52% 2.40% 11.50% 7.81% 3 1.0013 8.52% 2.40% 11.50% 7.81% 4 1.0013 8.52% 2.40% 11.50% 7.81% 5 1.0013 8.52% 2.40% 11.50% 7.81% 6 1.0010 8.52% 2.40% 13.20% 7.71% 7 1.0008 8.51% 2.40% 14.90% 7.60% 8 1.0005 8.51% 2.40% 16.60% 7.50% 9 1.0003 8.51% 2.40% 18.30% 7.39% 10 1.0000 8.51% 2.40% 20.00% 7.29%

234

III. Expected Growth

Aswath Damodaran

234

Expected Growth

Net Income Operating Income

Retention Ratio=1 - Dividends/Net Income

Return on EquityNet Income/Book Value of Equity

XReinvestment Rate = (Net Cap Ex + Chg in WC/EBIT(1-t)

Return on Capital =EBIT(1-t)/Book Value of Capital

X

235

Es]ma]ng growth in EPS: Deutsche Bank in January 2008

Aswath Damodaran

235

¨  In 2007, Deutsche Bank reported net income of 6.51 billion Euros on a book value of equity of 33.475 billion Euros at the start of the year (end of 2006), and paid out 2.146 billion Euros as dividends.

Return on Equity = Reten]on Ra]o =

¨  If Deutsche Bank maintains the return on equity (ROE) and reten]on ra]o that it delivered in 2007 for the long run:

Expected Growth Rate Exis]ng Fundamentals = 0.6703 * 0.1945 = 13.04% ¨  If we replace the net income in 2007 with average net income of $3,954 million,

from 2003 to 2007: Normalized Return on Equity = Normalized Reten]on Ra]o = Expected Growth Rate Normalized Fundamentals = 0.4572 * 0.1181 = 5.40%

€

Net Income2007

Book Value of Equity2006

=6,51033,475

=19.45%

€

1 −Dividends

Net Income=1 −

2,1466,510

= 67.03%

€

Average Net Income2003-07

Book Value of Equity2006

=3,95433,475

=11.81%

€

1 −Dividends

Net Income=1 −

2,1463,954

= 45.72%

236

Es]ma]ng growth in Net Income: Tata Motors

Aswath Damodaran

236

Year Net Income Cap Ex Depreciation Change in

WC Change in

Debt Equity

Reinvestment

Equity Reinvestment

Rate 2008-‐09 -‐25,053₹ 99,708₹ 25,072₹ 13,441₹ 25,789₹ 62,288₹ -‐248.63% 2009-‐10 29,151₹ 84,754₹ 39,602₹ -‐26,009₹ 5,605₹ 13,538₹ 46.44% 2010-‐11 92,736₹ 81,240₹ 46,510₹ 50,484₹ 24,951₹ 60,263₹ 64.98% 2011-‐12 135,165₹ 138,756₹ 56,209₹ 22,801₹ 30,846₹ 74,502₹ 55.12% 2012-‐13 98,926₹ 187,570₹ 75,648₹ 680₹ 32,970₹ 79,632₹ 80.50% Aggregate 330,925₹ 592,028₹ 243,041₹ 61,397₹ 120,160₹ 290,224₹ 87.70%

Year Net Income BV of Equity at start of the year ROE

2008-‐09 -‐25,053₹ 91,658₹ -‐27.33% 2009-‐10 29,151₹ 63,437₹ 45.95% 2010-‐11 92,736₹ 84,200₹ 110.14% 2011-‐12 135,165₹ 194,181₹ 69.61% 2012-‐13 98,926₹ 330,056₹ 29.97% Aggregate 330,925₹ 763,532₹ 43.34%

2013 value

Average values: 2008-‐2013

Reinvestment rate 80.50% 87.70% ROE 29.97% 43.34% Expected growth 24.13% 38.01%

237

ROE and Leverage

Aswath Damodaran

237

¨  A high ROE, other things remaining equal, should yield a higher expected growth rate in equity earnings.

¨  The ROE for a firm is a func]on of both the quality of its investments and how much debt it uses in funding these investments. In par]cular

ROE = ROC + D/E (ROC -‐ i (1-‐t)) where,

ROC = (EBIT (1 -‐ tax rate)) / (Book Value of Capital) BV of Capital = BV of Debt + BV of Equity -‐ Cash D/E = Debt/ Equity ra]o i = Interest rate on debt t = Tax rate on ordinary income.

238

Decomposing ROE

Aswath Damodaran

238

¨  Assume that you are analyzing a company with a 15% return on capital, an aYer-‐tax cost of debt of 5% and a book debt to equity ra]o of 100%. Es]mate the ROE for this company.

¨  Now assume that another company in the same sector has the same ROE as the company that you have just analyzed but no debt. Will these two firms have the same growth rates in earnings per share if they have the same dividend payout ra]o?

¨  Will they have the same equity value?

239

Es]ma]ng Growth in EBIT: Disney

¨  We started with the reinvestment rate that we computed from the 2013 financial statements:

Reinvestment rate = We computed the reinvestment rate in prior years to ensure that the 2013 values were not unusual or outliers.

¨  We compute the return on capital, using opera]ng income in 2013 and capital invested at the start of the year:

Return on Capital2013 = Disney’s return on capital has improved gradually over the last decade and has levelled off in the last two years.

¨  If Disney maintains its 2013 reinvestment rate and return on capital for the next five years, its growth rate will be 6.80 percent. Expected Growth Rate from Exis]ng Fundamentals = 53.93% * 12.61% = 6.8%

(3,629 + 103)10,032 (1-.3102)

= 53.93%

EBIT (1-t)(BV of Equity+ BV of Debt - Cash)

=10, 032 (1-.361)

(41,958+ 16,328 - 3,387)=12.61%

Aswath Damodaran

240

When everything is in flux: Changing growth and margins

¨  The elegant connec]on between reinvestment and growth in opera]ng income breaks down, when you have a company in transi]on, where margins are changing over ]me.

¨  If that is the case, you have to es]mate cash flows in three steps: ¤  Forecast revenue growth and revenues in future years, taking into account market poten]al and compe]]on.

¤  Forecast a “target” margin in the future and a pathway from current margins to the target.

¤  Es]mate reinvestment from revenues, using a sales to capital ra]o (measuring the dollars of revenues you get from each dollar of investment).

Aswath Damodaran

240

241

Here is an example: Baidu’s Expected FCFF

Aswath Damodaran

241

Year!Revenue growth! Revenues!

Operating Margin! EBIT! Tax rate!EBIT (1-t)!

Chg in Revenues!

Sales/Capital!

Reinvestment! FCFF!

Base year! ! $28,756 ! 48.72%! $14,009 !16.31%! $11,724 ! ! 2.64! ! !

1! 25.00%! $35,945 ! 47.35%! $17,019 !16.31%! $14,243 ! $7,189 ! 2.64! $2,722 ! $11,521 !2! 25.00%! $44,931 ! 45.97%! $20,657 !16.31%! $17,288 ! $8,986 ! 2.64! $3,403 ! $13,885 !3! 25.00%! $56,164 ! 44.60%! $25,051 !16.31%! $20,965 ! $11,233 ! 2.64! $4,253 ! $16,712 !4! 25.00%! $70,205 ! 43.23%! $30,350 !16.31%! $25,400 ! $14,041 ! 2.64! $5,316 ! $20,084 !5! 25.00%! $87,756 ! 41.86%! $36,734 !16.31%! $30,743 ! $17,551 ! 2.64! $6,646 ! $24,097 !6! 20.70%! $105,922 ! 40.49%! $42,885 !18.05%! $35,145 ! $18,166 ! 2.64! $6,878 ! $28,267 !7! 16.40%! $123,293 ! 39.12%! $48,227 !19.79%! $38,685 ! $17,371 ! 2.64! $6,577 ! $32,107 !8! 12.10%! $138,212 ! 37.74%! $52,166 !21.52%! $40,938 ! $14,918 ! 2.64! $5,649 ! $35,289 !9! 7.80%! $148,992 ! 36.37%! $54,191 !23.26%! $41,585 ! $10,781 ! 2.64! $4,082 ! $37,503 !

10! 3.50%! $154,207 ! 35.00%! $53,972 !25.00%! $40,479 ! $5,215 ! 2.64! $1,974 ! $38,505 !

242

IV. Geong Closure in Valua]on

Aswath Damodaran

242

¨  Since we cannot es]mate cash flows forever, we es]mate cash flows for a “growth period” and then es]mate a terminal value, to capture the value at the end of the period:

¨  When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash flows can be wri[en as: Value = Expected Cash Flow Next Period / (r -‐ g) where,

r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate forever.

¨  This “constant” growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates.

Value = CFt

(1+r)t+

Terminal Value(1+r)N

t=1

t=N∑

243

Geong to stable growth…

Aswath Damodaran

243

¨  A key assump]on in all discounted cash flow models is the period of high growth, and the pa[ern of growth during that period. In general, we can make one of three assump]ons: ¤  there is no high growth, in which case the firm is already in stable growth ¤  there will be high growth for a period, at the end of which the growth rate

will drop to the stable growth rate (2-‐stage) ¤  there will be high growth for a period, at the end of which the growth rate

will decline gradually to a stable growth rate(3-‐stage) ¨  The assump]on of how long high growth will con]nue will depend

upon several factors including: ¤  the size of the firm (larger firm -‐> shorter high growth periods) ¤  current growth rate (if high -‐> longer high growth period) ¤  barriers to entry and differen]al advantages (if high -‐> longer growth

period)

244

Choosing a Growth Period: Examples

Aswath Damodaran

244

Disney Vale Tata Motors Baidu Firm size/market size

Firm is one of the largest players in the entertainment and theme park business, but the businesses are being redefined and are expanding.

The company is one of the largest mining companies in the world, and the overall market is constrained by limits on resource availability.

Firm has a large market share of Indian (domestic) market, but it is small by global standards. Growth is coming from Jaguar division in emerging markets.

Company is in a growing sector (online search) in a growing market (China).

Current excess returns

Firm is earning more than its cost of capital.

Returns on capital are largely a function of commodity prices. Have generally exceeded the cost of capital.

Firm has a return on capital that is higher than the cost of capital.

Firm earns significant excess returns.

Competitive advantages

Has some of the most recognized brand names in the world. Its movie business now houses Marvel superheros, Pixar animated characters & Star Wars.

Cost advantages because of access to low-cost iron ore reserves in Brazil.

Has wide distribution/service network in India but competitive advantages are fading there.Competitive advantages in India are fading but Landrover/Jaguar has strong brand name value, giving Tata pricing power and growth potential.

Early entry into & knowledge of the Chinese market, coupled with government-imposed barriers to entry on outsiders.

Length of high-growth period

Ten years, entirely because of its strong competitive advantages/

None, though with normalized earnings and moderate excess returns.

Five years, with much of the growth coming from outside India.

Ten years, with strong excess returns.


Valuing Vale in November 2013 (in US dollars)Let's start with some history & estimate what a normalized year will look like

Assume that the company is in stable growth, growing 2% a year in perpetuity

Estimate the costs of equity & capital for Vale

Business Sample,size

Unlevered,beta,of,business Revenues

Peer,Group,EV/Sales

Value,of,Business

Proportion,of,Vale

Metals'&'Mining 48 0.86 $9,013 1.97 $17,739 16.65%Iron'Ore 78 0.83 $32,717 2.48 $81,188 76.20%Fertilizers 693 0.99 $3,777 1.52 $5,741 5.39%Logistics 223 0.75 $1,644 1.14 $1,874 1.76%Vale,Operations 0.8440 $47,151 $106,543 100.00%

Market D/E = 54.99%Marginal tax rate = 34.00% (Brazil)Levered Beta = 0.844 (1+(1-.34)(.5499) = 1.10Cost of equity = 2.75% + 1.10 (7.38%) = 11.23%

Year Operating+Income+($) Effective+tax+rate+ BV+of+Debt BV+of+Equity Cash Invested+capital Return+on+capital

2009 $6,057 27.79% $18,168 $42,556 $12,639 $48,085 9.10%

2010 $23,033 18.67% $23,613 $59,766 $11,040 $72,339 25.90%

2011 $30,206 18.54% $27,668 $70,076 $9,913 $87,831 28.01%

2012 $13,346 18.96% $23,116 $78,721 $3,538 $98,299 11.00%

2013+(TTM) $15,487 20.65% $30,196 $75,974 $5,818 $100,352 12.25%

Normalized $17,626 20.92% 17.25%

%"of"revenues ERPUS & Canada 4.90% 5.50%Brazil 16.90% 8.50%Rest of Latin America 1.70% 10.09%China 37.00% 6.94%Japan 10.30% 6.70%Rest of Asia 8.50% 8.61%Europe 17.20% 6.72%Rest of World 3.50% 10.06%Vale ERP 100.00% 7.38%Vale's rating: A-Default spread based on rating = 1.30%Cost of debt (pre-tax) = 2.75% + 1.30% = 4.05%

Cost of capital = 11.23% (.6452) + 4.05% (1-.34) (.3548) = 8.20%

!"#$%"&'("$'!!"#$ = ! !!"# = !

2%17.25% = 11.59%!

!"#$%!!"!!"#$%&'()!!""#$" = !17,626! 1− .2092 1− !. 1159. 082− .02 = $202,832!

Value of operating assets = $202,832+ Cash & Marketable Securities = $ 7,133- Debt = $ 42,879Value of equity = $167,086Value per share =$ 32.44Stock price (11/2013) = $ 13.57

246

Es]ma]ng Stable Period Inputs aYer a high growth period: Disney ¨  Respect the cap: The growth rate forever is assumed to be 2.5. This is set lower

than the riskfree rate (2.75%). ¨  Stable period excess returns: The return on capital for Disney will drop from its

high growth period level of 12.61% to a stable growth return of 10%. This is s]ll higher than the cost of capital of 7.29% but the compe]]ve advantages that Disney has are unlikely to dissipate completely by the end of the 10th year.

¨  Reinvest to grow: Based on the expected growth rate in perpetuity (2.5%) and expected return on capital forever aYer year 10 of 10%, we compute s a stable period reinvestment rate of 25%: ¨  Reinvestment Rate = Growth Rate / Return on Capital = 2.5% /10% = 25%

¨  Adjust risk and cost of capital: The beta for the stock will drop to one, reflec]ng Disney’s status as a mature company.

¤  Cost of Equity = Riskfree Rate + Beta * Risk Premium = 2.75% + 5.76% = 8.51% ¤  The debt ra]o for Disney will rise to 20%. Since we assume that the cost of debt remains

unchanged at 3.75%, this will result in a cost of capital of 7.29% ¤  Cost of capital = 8.51% (.80) + 3.75% (1-‐.361) (.20) = 7.29%

Aswath Damodaran

247

V. From firm value to equity value per share

Aswath Damodaran

247

Approach used To get to equity value per share Discount dividends per share at the cost of equity

Present value is value of equity per share

Discount aggregate FCFE at the cost of equity

Present value is value of aggregate equity. Subtract the value of equity options given to managers and divide by number of shares.

Discount aggregate FCFF at the cost of capital

PV = Value of operating assets + Cash & Near Cash investments + Value of minority cross holdings - Debt outstanding = Value of equity - Value of equity options =Value of equity in common stock / Number of shares

248

Valuing Deutsche Bank in early 2008

Aswath Damodaran

248

¨  To value Deutsche Bank, we started with the normalized income over the previous five years (3,954 million Euros) and the dividends in 2008 (2,146 million Euros). We assumed that the payout ra]o and ROE, based on these numbers will con]nue for the next 5 years: ¤  Payout ra]o = 2,146/3954 = 54.28% ¤  Expected growth rate = (1-‐.5428) * .1181 = 0.054 or 5.4% ¤  Cost of equity = 9.23%

249

Deutsche Bank in stable growth

Aswath Damodaran

249

¨  At the end of year 5, the firm is in stable growth. We assume that the cost of equity drops to 8.5% (as the beta moves to 1) and that the return on equity also drops to 8.5 (to equal the cost of equity). Stable Period Payout Ra]o = 1 – g/ROE = 1 – 0.03/0.085 = 0.6471 or 64.71% Expected Dividends in Year 6 = Expected Net Income5 *(1+gStable)* Stable Payout Ra]o

= €5,143 (1.03) * 0.6471 = €3,427 million Terminal Value =

PV of Terminal Value =

¨  Value of equity = €9,653+ €40,079 = €49,732 million Euros ¨  Value of equity per share=

Stock was trading at 89 Euros per share at the ]me of the analysis.

Expected Dividends6

(Cost of Equity-g)=

3,247(.085-.03)

= 62,318 million Euros

Terminal Valuen

(1+Cost of EquityHigh growth )n=

62,318(1.0923)5 = 40, 079 mil Euros

Value of Equity# Shares

=49,732474.2

=104.88 Euros/share

250

Valuing Deutsche Bank in 2013

Aswath Damodaran

250

Current 1 2 3 4 5 Steady state Risk Adjusted Assets (grows 3% a year for next 5 years) 439,851 € 453,047 € 466,638 € 480,637 € 495,056 € 509,908 € 517,556 € Tier 1 Capital ratio (increases from 15.13% to 18.00% over next 5 years 15.13% 15.71% 16.28% 16.85% 17.43% 18.00% 18.00% Tier 1 Capital (Risk Adjusted Assets * Tier 1 Capital Ratio) 66,561 € 71,156 € 75,967 € 81,002 € 86,271 € 91,783 € 93,160 €

Change in regulatory capital (Tier 1) 4,595 € 4,811 € 5,035 € 5,269 € 5,512 € 1,377 € Book Equity 76,829 € 81,424 € 86,235 € 91,270 € 96,539 € 102,051 € 103,605 € ROE (expected to improve from -1.08% to 8.00% in year 5) -1.08% 0.74% 2.55% 4.37% 6.18% 8.00% 8.00% Net Income (Book Equity * ROE) -716 € 602 € 2,203 € 3,988 € 5,971 € 8,164 € 8,287 € - Investment in Regulatory Capital 4,595 € 4,811 € 5,035 € 5,269 € 5,512 € 1,554 € FCFE -3,993 € -2,608 € -1,047 € 702 € 2,652 € 6,733 € Terminal value of equity 103,582.19 € Present value -3,669.80 € -2,202.88 € -812.94 € 500.72 € 69,671.28 € Cost of equity 8.80% 8.80% 8.80% 8.80% 8.80% 8.80% 8.00% Value of equity today = 63,486.39 € Number of shares outstanding = 1019.50 Value per share = 62.27 € Stock price in November 2013 = 35.46 €

251

Valuing Tata Motors with a FCFE model in November 2013: The high growth period

Aswath Damodaran

251

¨  We use the expected growth rate of 24.13%, es]mated based upon the 2013 values for ROE (29.97%) and equity reinvestment rate (80.5%): ¨  Expected growth rate = 29.97% * 80.5% = 24.13%

¨  The cost of equity for Tata Motors is 13.50%: Cost of equity = = 6.57% + 0.964 (7.19%) = 13.50%

¨  The expected FCFE for the high growth period Current 1 2 3 4 5 Expected growth rate 24.13% 24.13% 24.13% 24.13% 24.13% Net Income 98,926₹ 122,794₹ 152,420₹ 189,194₹ 234,841₹ 291,500₹ Equity Reinvestment Rate 80.50% 80.50% 80.50% 80.50% 80.50% 80.50% Equity Reinvestment 79,632₹ 98,845₹ 122,693₹ 152,295₹ 189,039₹ 234,648₹

FCFE 19,294₹ 23,949₹ 29,727₹ 36,899₹ 45,802₹ 56,852₹ PV of [email protected]% 21,100₹ 23,075₹ 25,235₹ 27,597₹ 30,180₹

Sum of PV of FCFE = 127,187₹

252

Stable growth and value….

Aswath Damodaran

252

¨  AYer year five, we will assume that the beta will increase to 1 and that the equity risk premium will decline to 6.98% percent (as the company becomes more global). The resul]ng cost of equity is 13.55 percent.

Cost of Equity in Stable Growth = 6.57% + 1(6.98%) = 13.55% ¨  We will assume that the growth in net income will drop to 6% and that

the return on equity will drop to 13.55% (which is also the cost of equity). Equity Reinvestment Rate Stable Growth = 6%/13.55% = 44.28% FCFE in Year 6 = ₹291,500(1.06)(1 – 0.4428) = ₹ 136,822million Terminal Value of Equity = ₹136,822/(0.1355 – 0.06) = ₹ 2,280,372 million

¨  To value equity in the firm today Value of equity = PV of FCFE during high growth + PV of terminal value

= ₹127,187 + 2,280,372/1.13555 = ₹742,008 million ¤  Dividing by 2694.08 million shares yields a value of equity per share of ₹275.42,

about 40% lower than the stock price of ₹427.85 per share.


Term yrEBIT (1-t) 41,896- Reinv 9.776FCFF 32,120

Terminal Value10= 32,120/(.10-035) = ¥494,159

Cost of capital = 12.91% (.9477) + 3.45% (.0523) = 12.42%

Unlevered Beta for Businesses: 1.30

ERP8.77%

Operating assets ¥291,618+ Cash 43,300- Debt 20,895Value of equity 314,023/ No of shares 2088.87 Value/share ¥150.33

Cost of Debt(3.5%+0.8%+0.3%)(1-.25) = 3.45%

Cost of Equity12.91%

Stable Growthg = 3.5%

Cost of capital = 10% ROC= 15%;

Reinvestment Rate=3.5%/15% = 23.33%

WeightsE = 94.77% D = 5.23%

Riskfree Rate:Riskfree rate = 3.5% +

Beta 1.356 X

In November 2013, the stock was trading at ¥160.06 per share.

Cost of capital decreases to 10% from years 6-10

D/E=5.52%

Baidu: My valuation (November 2013)Revenue

growth of 25% a year for 5 years, tapering down to 3.5% in year

10

Pre-tax operating

margin decreases to

35% over time

Sales to capital ratio

maintained at 2.64 (current

level)

Country % of Revenues ERPBrazil 34.30% 8.75%Chile 15.70% 6.95%United States 13.00% 5.75%Argentina 9.20% 15.88%Peru 6.40% 8.75%Colombia 3.80% 9.13%Ecuador 2.70% 17.75%W. Europe 7.60% 6.97%Asia 7.30% 7.52%

100.00% 8.77%

1 3 3 4 5 6 7 8 9 10Revenue growth 25.00% 25.00% 25.00% 25.00% 25.00% 20.70% 16.40% 12.10% 7.80% 3.50%Revenues ¥35,945 ¥44,931 ¥56,164 ¥70,205 ¥87,756 ¥105,922 ¥123,293 ¥138,212 ¥148,992 ¥154,207Operating Margin 47.35% 45.97% 44.60% 43.23% 41.86% 40.49% 39.12% 37.74% 36.37% 35.00%EBIT ¥17,019 ¥20,657 ¥25,051 ¥30,350 ¥36,734 ¥42,885 ¥48,227 ¥52,166 ¥54,191 ¥53,972Tax rate 16.31% 16.31% 16.31% 16.31% 16.31% 18.05% 19.79% 21.52% 23.26% 25.00%EBIT (1-t) ¥14,243 ¥17,288 ¥20,965 ¥25,400 ¥30,743 ¥35,145 ¥38,685 ¥40,938 ¥41,585 ¥40,479 - Reinvestment ¥2,722 ¥3,403 ¥4,253 ¥5,316 ¥6,646 ¥6,878 ¥6,577 ¥5,649 ¥4,082 ¥1,974FCFF ¥11,521 ¥13,885 ¥16,712 ¥20,084 ¥24,097 ¥28,267 ¥32,107 ¥35,289 ¥37,503 ¥38,505

Last%12%months Last%yearRevenues ¥28,756 ¥22,306Operating income or EBIT ¥14,009 ¥11,051Operating Margin 48.72% 49.54%Revenue Growth 28.92%Sales/Capital Ratio 2.64

254

Disney: Inputs to Valua]on

High Growth Phase Transition Phase Stable Growth Phase

Length of Period 5 years 5 years Forever after 10 years

Tax Rate 31.02% (Effective)

36.1% (Marginal)

31.02% (Effective)

36.1% (Marginal)

31.02% (Effective)

36.1% (Marginal)

Return on Capital 12.61% Declines linearly to 10% Stable ROC of 10%

Reinvestment Rate

53.93% (based on normalized

acquisition costs)

Declines gradually to 25%

as ROC and growth rates

drop:

25% of after-tax operating

income.

Reinvestment rate = g/ ROC

= 2.5/10=25%

Expected Growth

Rate in EBIT

ROC * Reinvestment Rate =

0.1261*.5393 = .068 or 6.8%

Linear decline to Stable

Growth Rate of 2.5%

2.5%

Debt/Capital Ratio 11.5% Rises linearly to 20.0% 20%

Risk Parameters Beta = 1.0013, ke = 8.52%%

Pre-tax Cost of Debt = 3.75%

Cost of capital = 7.81%

Beta changes to 1.00;

Cost of debt stays at 3.75%

Cost of capital declines

gradually to 7.29%

Beta = 1.00; ke = 8.51%

Cost of debt stays at 3.75%

Cost of capital = 7.29%

Aswath Damodaran

Aswath Damodaran

Term Yr10,6392,6607,980

Terminal Value10= 7,980/(.0729-.025) = 165,323

Cost of Capital (WACC) = 8.52% (0.885) + 2.40% (0.115) = 7.81%

Return on Capital12.61%

Reinvestment Rate 53.93%

Unlevered Beta for Sectors: 0.9239

ERP for operations5.76%Beta

1.0013Riskfree Rate:Riskfree rate = 2.75%

Op. Assets 125,477+ Cash: 3,931+ Non op inv 2,849- Debt 15,961- Minority Int 2,721=Equity 113,575-Options 972Value/Share $ 62.56

WeightsE = 88.5% D = 11.5%

Cost of Debt(2.75%+1.00%)(1-.361)

= 2.40%Based on actual A rating

Cost of Equity8.52%

Stable Growthg = 2.75%; Beta = 1.00;

Debt %= 20%; k(debt)=3.75Cost of capital =7.29%

Tax rate=36.1%; ROC= 10%; Reinvestment Rate=2.5/10=25%

Expected Growth .5393*.1261=.068 or 6.8%

Current Cashflow to FirmEBIT(1-t)= 10,032(1-.31)= 6,920- (Cap Ex - Deprecn) 3,629 - Chg Working capital 103= FCFF 3,188Reinvestment Rate = 3,732/6920

=53.93%Return on capital = 12.61%

+ X

Disney - November 2013

In November 2013, Disney was trading at $67.71/share

First 5 years

D/E=13.10%

1 2 3 4 5 6 7 8 9 10EBIT/*/(1/2/tax/rate) $7,391 $7,893 $8,430 $9,003 $9,615 $10,187 $10,704 $11,156 $11,531 $11,819/2/Reinvestment $3,985 $4,256 $4,546 $4,855 $5,185 $4,904 $4,534 $4,080 $3,550 $2,955FCFF $3,405 $3,637 $3,884 $4,148 $4,430 $5,283 $6,170 $7,076 $7,981 $8,864

Growth declines gradually to 2.75%

Cost of capital declines gradually to 7.29%

Aswath Damodaran

Cost of capital = 8.52% (.885) + 2.4% (.115) = 7.81%

Financing ChoicesMostly US $ debt with duration of 6

years

Financing MixD=11.5%; E=88.5%

Expected Growth Rate = 12.61% * 53.93%= 6.8%

Current EBIT (1-t)$ 6,920

Reinvestment Rate53.93%

New InvestmentsReturn on Capital

12.61%

The Financing DecisionChoose a financing mix that minimizes the hurdle rate and match your financing to your assets.

The Dividend DecisionIf you cannot find investments that earn more than the hurdle rate, return the cash to the owners of the businesss.

The Investment DecisionInvest in projects that earn a return greater than a minimum acceptable hurdle rate

Investment decision affects risk of assets being finance and financing decision affects hurdle rate

Stra

tegi

c in

vest

men

ts d

eter

min

e le

ngth

of g

rowt

h pe

riod

Disney: Corporate Financing Decisions and Firm Value

Existing InvestmentsROC = 12.61%

Year Expected+Growth EBIT+(15t) Reinvestment FCFF Terminal+Value Cost+of+capital PV1 6.80% $7,391 $3,985 $3,405 7.81% $3,1582 6.80% $7,893 $4,256 $3,637 7.81% $3,1293 6.80% $8,430 $4,546 $3,884 7.81% $3,0994 6.80% $9,003 $4,855 $4,148 7.81% $3,0705 6.80% $9,615 $5,185 $4,430 7.81% $3,0416 5.94% $10,187 $4,904 $5,283 7.71% $3,3677 5.08% $10,704 $4,534 $6,170 7.60% $3,6548 4.22% $11,156 $4,080 $7,076 7.50% $3,8999 3.36% $11,531 $3,550 $7,981 7.39% $4,09410 2.50% $11,819 $2,955 $8,864 $189,738 7.29% $94,966

Value of operating assets of the firm = $125,477Value of Cash & Non-operating assets = $6,780Value of Firm = $132,257Market Value of outstanding debt = $15,961Minority Interests $2,721Market Value of Equity = $113,575Value of Equity in Options = $972Value of Equity in Common Stock = $112,603Market Value of Equity/share = $62.56

257

Ways of changing value…

Cashflows from existing assetsCashflows before debt payments, but after taxes and reinvestment to maintain exising assets

Expected Growth during high growth period

Growth from new investmentsGrowth created by making new investments; function of amount and quality of investments

Efficiency GrowthGrowth generated by using existing assets better

Length of the high growth periodSince value creating growth requires excess returns, this is a function of- Magnitude of competitive advantages- Sustainability of competitive advantages

Stable growth firm, with no or very limited excess returns

Cost of capital to apply to discounting cashflowsDetermined by- Operating risk of the company- Default risk of the company- Mix of debt and equity used in financing

How well do you manage your existing investments/assets?

Are you investing optimally forfuture growth? Is there scope for more

efficient utilization of exsting assets?

Are you building on your competitive advantages?

Are you using the right amount and kind of debt for your firm?

Aswath Damodaran

Aswath Damodaran

Term Yr12,2753,0699,206

Terminal Value10= 9,206/(.0676-.025) = 216,262

Cost of Capital (WACC) = 8.52% (0.60) + 2.40%(0.40) = 7.16%

Return on Capital14.00%

Reinvestment Rate 50.00%

Unlevered Beta for Sectors: 0.9239

ERP for operations5.76%Beta

1.3175Riskfree Rate:Riskfree rate = 2.75%

Op. Assets 147,704+ Cash: 3,931+ Non op inv 2,849- Debt 15,961- Minority Int 2,721=Equity 135,802-Options 972Value/Share $ 74.91

WeightsE = 60% D = 40%

Cost of Debt(2.75%+1.00%)(1-.361)

= 2.40%Based on synthetic A rating

Cost of Equity10.34%

Stable Growthg = 2.75%; Beta = 1.20;

Debt %= 40%; k(debt)=3.75%Cost of capital =6.76%

Tax rate=36.1%; ROC= 10%; Reinvestment Rate=2.5/10=25%

Expected Growth .50* .14 = .07 or 7%

Current Cashflow to FirmEBIT(1-t)= 10,032(1-.31)= 6,920- (Cap Ex - Deprecn) 3,629 - Chg Working capital 103= FCFF 3,188Reinvestment Rate = 3,732/6920

=53.93%Return on capital = 12.61%

+ X

Disney (Restructured)- November 2013

In November 2013, Disney was trading at $67.71/share

First 5 years

D/E=66.67%

Growth declines gradually to 2.75%

Cost of capital declines gradually to 6.76%

More selective acquisitions & payoff from gaming

Move to optimal debt ratio, with higher beta.

1 2 3 4 5 6 7 8 9 10EBIT * (1 - tax rate) $7,404 $7,923 $8,477 $9,071 $9,706 $10,298 $10,833 $11,299 $11,683 $11,975 - Reinvestment $3,702 $3,961 $4,239 $4,535 $4,853 $4,634 $4,333 $3,955 $3,505 $2,994Free Cashflow to Firm $3,702 $3,961 $4,239 $4,535 $4,853 $5,664 $6,500 $7,344 $8,178 $8,981

259

First Principles

Aswath Damodaran

259



rate













assets.


return depends upon

current & potential








Documents

CORPORATE FINANCE LECTURE NOTE PACKET 2 CAPITAL